Here's One Major Mistake to Avoid if You're Investing in ETFs | The Motley Fool (2024)

While they're not a new phenomenon in investing, exchange-traded funds (ETFs) have risen noticeably in popularity over the past couple of decades. For good reason, too. ETFs are generally low-cost and are a great way for investors to gain diversification and broad market exposure in a single investment.

However, with the increased use of ETFs comes a mistake you want to avoid: unknowingly overlapping companies to the point where it concentrates your portfolio more than preferred.

The two main ways that funds allocate assets

Before talking about ETF overlap, it's important for to understand how an ETF allocates its funds across stocks, because it can affect the level of overlap.

Most funds allocate assets in one of two ways. The first and most straightforward way is equal-weighted, which means the money you invest is equally split between the stocks the fund holds. If a fund has 500 companies and you invest $500, each would get $1; if you invest $5,000, each would get $10; If you invest $5, each would get $0.01; and so forth.

The other primary method is distributing investments by the companies' market capitalizations (market caps). In this case, companies with a higher market cap receive more of the invested amount. For example, if a fund has 500 companies, a $1,000 investment could mean $5 to the largest company in the fund, while $0.10 goes to the smallest. The exact distributions will vary based on the range of market caps in the fund.

Be aware of the overlap between companies

ETF overlap happens when investors have multiple ETFs that contain many of the same stocks. For example, many large-cap and broad-market ETFs include companies like Apple, Microsoft, Amazon, Nvidia, and Alphabet.

Two common examples are the SPDR S&P 500 ETF Trust (SPY -0.20%) and the Invesco QQQ Trust (QQQ 0.08%), which follow two of the stock market's most popular indexes: the S&P 500 and Nasdaq-100. Below are the top 10 holdings for each of those ETFs:

Data source: Fund holding documents.

It's one thing to have overlapping companies in ETFs you own, but the issue is when these companies make up a significant percentage of them. The eight companies that overlap between the above two ETFs make up over 28% of the SPDR S&P 500 ETF Trust and over 44% of the Invesco QQQ Trust. There are 84 overlapping holdings in total.

One of the main selling points of ETFs is the diversification you receive with a single investment. A diversified portfolio should ideally reduce the impact of volatility and put you in a position for higher returns over time. When your ETFs have too much overlap, this concentration can negate some of those benefits, potentially leading to higher volatility and reliance on too few companies.

Let your ETFs complement each other

When looking into ETFs to invest in, the goal should be to have ones that complement each other instead of duplicating each other. That's one of the best ways to minimize any overlap between them.

For example, if you're already invested in a large-cap, tech-heavy ETF like the Invesco QQQ Trust, you might consider an ETF focused on a different sector. Similarly, if you're invested in a broad large-cap fund like the SPDR S&P 500 ETF Trust, you might consider a small-cap or mid-cap-focused ETF.

This isn't to say you shouldn't invest in both ETFs in our example, but it's essential to monitor how much the top holdings begin to account for your portfolio. Several tools and brokerage platforms will analyze your portfolio to let you know where your ETF overlap is, simplifying the work for you.

Reviewing your portfolio regularly and adjusting your holdings as needed can help you maintain diversification. This is especially important because market movements can change the weightings of holdings in some ETFs.