Investors have flocked to ETFs in order to give themselves exposure to entire sectors of the market.
Lost on most investors is the problem of concentration risk. Concentration risk occurs when a small number of holdings make up a disproportionate amount of the new asset weighting. This causes the ETF and underlying index upon which it is based to become more beholden to moves in just a few stocks, lowering the diversification sought by investors.
When concentration risk is evident in an ETF an investor has to ask themselves if they would be better off buying the top names in the ETF instead.
Two Sector SPDR ETFs are showing the potential for concentration risk based upon their December 31, 2011, holdings. Investors should be aware of the potential risk in these ETFs and manage their risk exposure accordingly.
The first is the Consumer Staples SPDR (NYSEARCA:XLP) focusing on companies in the retail, food and beverage, and household products subsectors. A significant portion of the ETFs investments are large-cap, global, S&P 500 index companies.
Looking at the holdings as of January 23rd the top four holdings make up almost 40% of the fund's NAV as shown below.
- Proctor & Gamble (NYSE:PG) - 14.07%
- Philip Morris International Inc. (NYSE:PM) - 10.23%
- Wal-Mart Stores Inc. (NYSE:WMT) - 8.37%
- Coca-Cola Co. (NYSE:KO) - 7.18%
The top four holdings account for 39.85% of the NAV exposing investors to wild swings in the ETF while marginalizing the potential gains from holdings with smaller weightings.
The second ETF is the Energy SPDR (NYSEARCA:XLE) focusing on companies in the oil, gas and services industries.
The top three holdings in the Energy SPDR account for more than 40% of the NAV as seen below:
- Exxon Mobil Corp. (NYSE:XOM) - 19.12%
- Chevron Corp. (NYSE:CVX) - 14.71%
- Schlumberger Ltd. (NYSE:SLB) - 7.02%
The 19% weighting for Exxon Mobil and 14.7% for Chevron indicates a significant concentration of net assets in just two holdings. Should there be any negative surprises in either stocks the ETF would become more volatile.
When a significant amount of net assets are concentrated in a few stocks investors need to ask themselves if they would be better off adding the top names in the portfolio versus buying the ETF itself.
Investors considering ETFs for diversification purposes should be aware of the potential for concentration risk as the diversification they seek may be less than they acquire.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Source: S&P SPDR's website.