Like any pre-packaged meal or prepared food product, many may choose to look at the nutrition facts and ingredients of what makes up the product about to be purchased, and many may not.
Here’s why I believe it’s so important for investors to take a look under the hood to understand exactly which companies are held in an ETF they may be considering, and in what quantities.
Perhaps the most important reason why it’s important for investors to know what is held within a given exchange traded fund (ETF) is the reality that various ETF names do not necessarily correlate with the fund’s holdings.
This can happen for various reasons. For example, common terminology such as “large cap” can be used to determine the companies which can be held by an ETF, and while this distinction is universal, the boundaries which separate mid cap from large cap can differ across funds.
Similarly, how a fund may determine that a group of stocks represent “value” may differ significantly from the methodology of another similar ETF. In finance, ubiquitous terms are often used, which often remain broad enough to invite a host of differing methodologies to stratify stocks based on certain criteria.
The other important factor investors ought to consider is that the top five or 10 holdings in an ETF often make up a sizable chunk of the fund, enough to move the ETF up or down on individual stock performance.
If you’re finding that the ETF you’re considering is top-heavy (i.e. too few stocks holding too much allocation in a fund), it may be best to look for other more diversified options. After all, you’re buying an ETF for the low-cost diversification these products get you, and if you wanted exposure to a group of five stocks, for example, you’d just buy those individual holdings on your own.
Invest wisely, my friends.
