One of the many appealing attributes of ETFs is the ability to achieve broad exposure through the purchase of a single ticker, thereby whittling away any company-specific risk that comes with individual stock picking. While the “instant diversification” provided by ETFs and mutual funds can go a long way towards minimizing the impact of a single security on bottom line returns, it is important to note that certain ETFs can still feel the pinch from poor performances out of a single stock.
For starters, not all ETFs are created equal in terms of balance and depth of the underlying portfolios. While some stock ETFs have thousands of individual holdings and don’t assign a weight of more than 1% to any single security, others are more top heavy in a few big names. For example, ExxonMobil (NYSE:XOM) accounts for about 19% of the Energy SPDR (NYSEARCA:XLE), with Chevron (NYSE:CVX) making up another 15% or so. Among international equity ETFs, it isn’t uncommon to allocate more than 10% to an individual stock–generally one that is found in the energy or financial sector. That concentration can obviously translate into material company-specific risk; if the stock in question performs well, it can be good news for the entire fund. If the largest weighting struggles, however, a single name can offset stellar gains from other, smaller components.
Single stocks can also go a long ways towards determining the returns of an ETF when their returns are outliers, meaning that they deviate significantly from the average of the peer group. For example, the significant deviations in biotech ETFs last year were attributable to the discrepancies in weightings afforded to stocks that had become takeover targets or reported positive breakthrough and posted massive gains. The hefty weight in FBT to Sequenon added almost 800 basis points to the fund’s performance relative to ETFs that excluded the stock [see Is Your Biotech ETF A Leader Or A Laggard?].
On the flip side of that coin, a steep decline in a single stock can potentially have a material adverse impact on an entire fund. For example, Bank of America (NYSE:BAC) witnessed an epic collapse in stock price in 2011; shares were down close to 60% on the year. That abysmal performance, combined with the unique weighting methodologies employed by some ETFs, created some tough times for several products that make big allocations to the struggling financial giant:
1. RevenueShares Financials Sector Fund (NYSEARCA:RWW)
This ETF consists of the exact same holdings as the more popular Financial SPDR (NYSEARCA:XLF), but utilizes a unique approach to determine the weightings assigned to each. The idea is to break the link between stock price and index weight, shifting exposure towards stocks with low price-to-sales multiples. So far in 2011 that strategy hasn’t worked out too well, as the relative overweight position in BAC is a primary culprit for RWW’s disappointing performance. BAC is one of the largest holdings in RWW with almost 10% of assets, on par with Berkshire Hathaway–even though the Buffett-controlled stock has a considerably larger market cap [see RWW Holdings].
This ETF was down about 25% on the year, putting it about 700 basis points behind XLF. BAC is one of the reason for that disconnect between two ETFs with identical holdings.
2. RAFI Fundamental Pure Large Value Portfolio (NYSEARCA:PXLV)
This ETF offers exposure to large cap value stocks–as do a number of other products. One of the features that makes PXLV unique, however, is the weighting methodology employed; instead of giving the biggest weightings to the largest companies, the underlying index considers four fundamental measures of firm size: cash flow, sales, dividends, and book value [see Does Your Portfolio Need a RAFI ETF?].
Though BAC hasn’t been making significant dividend payouts to shareholders, the company boasts well more than $100 billion in annual revenue and maintains a book value of equity north of $200 billion–making it one of the largest companies in the world based on those measures. That means a big weight in PXLV; Bank of America made up about 5% of this ETF at the end of 2011, though the weighting has dropped a bit since.
3. Dow Jones U.S. Financial Services Index Fund (NYSEARCA:IYG)
This ETF has also felt the wrath of BAC’s slide, even though the company is no longer among the top three holdings. The steep decline in share prices in BAC stock has pushed the weighting in IYG down to only about 5%, behind Wells Fargo, JPMorgan, and Citigroup (at the end of Q3, BAC was at about 6% of assets).
Still, the relatively large weighting (which was considerably higher earlier in the year) has contributed to a miserable year for this fund; IYG was down about 20% on the year in 2011, and has lost close to 65% of its value over the last five years. That steep sell-off is attributable in no small part to BAC, which has shed almost 90% of its value during that same period.
The adverse impact of BAC on these ETFs in 2011 serves as an interesting case study in the nuances of weighting methodologies. ETFs linked to methodologies that utilize metrics besides market cap (such as RWW and PXLV) have the potential to exhibit contrarian tendencies in certain environments. As BAC’s stock price slid–it was a remarkably steady collapse throughout the course of the year–its allocation in cap-weighted indexes dropped off sharply. But ETFs that determine individual stock weights based on factors such as revenue or book value continued to assign a significant weighting to BAC, in some cases purchasing additional shares upon at rebalancings to bring the weight back in line with the size indicated by the relevant metrics.
In other words, when declines in stock prices precede or outpace declines in metrics such as revenue, book value, or dividends paid, some alternative weighting methodologies will have a tendency to pump more cash into stocks on the decline. In the case of BAC in 2011, that wasn’t the best approach.
There is, of course, a flip side to this approach that can (and often does) result in big payoffs. When beaten down stocks bounce back and gain ground, funds that beefed up exposure at the bottom are handsomely rewarded. And a single year is a relatively short period of time over which to evaluate the performance of any one methodology. But it’s certainly some food for thought; the biases implemented by weighting methodologies aren’t always apparent, but are always important to consider.
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