How many elephants do you own?

Today, many investors use Exchange Traded Funds (ETFs) as their main investment vehicles. ETFs have many advantages: they are liquid, have relatively low management fees, transparent and, usually, are fairly diversified. However, not all ETFs are built equal, and some carry risks that may not be so visible at a first glance.

While some of these ETFs are relatively easy to understand, the complexity begins to compound fast as additional investments are added. Although it could be relatively easy to grasp the concept of a “classic” portfolio consisting of a 60% global stock index and a 40% global bond index, once the portfolios gain more exposure via additional funds, the picture can become more complex and the risks can become harder to identify.

Let us discuss one of these risks: concentration risk. Concentration risk could be defined as a risk an investor is undertaking when investing in a portfolio of only a few holdings. In such a portfolio, an individual holding exposes the investor to a higher degree of risk. Of course, Concentration risk becomes more apparent when holdings exhibit high price volatility. A good example of such a holding can be Apple Inc. (NASDAQ:AAPL). Apple had a price of $411 on January 3, 2012, proceeded to reach $700 in September 2012 and gave up all of those gains, finishing at $413 on June 21, 2013.

It makes sense to assume that if an investor owned an ETF with a concentrated (i.e. large) Apple position, his portfolio would have, as a result, experienced a higher degree of volatility. How many such ETFs are out there?

By screening ETF Database (etfdb.com), I found 20 ETFs that had a 5% or higher Apple exposure. To illustrate the potential impact of such concentration, let us construct a hypothetical portfolio of ETFs for an investor who is bullish on the US Technology Sector:

20% Dow Jones U.S. Technology Index Fund (16.9% in AAPL, 135 holdings)
40% iShares Core S&P 500 ETF (2.7% in AAPL, 501 holdings)
40% iShares Core Total U.S. Bond Market ETF (0% in AAPL, 1918 holdings)

Such a portfolio would have a total 4.5% Apple weighting. To drive the point further, while Apple represents only 0.04% of total holdings (1/2554), it has a significantly disproportionate weighting of 4.5%.

To visualize our result, let us engage in a brief mathematical exercise: assume that we gathered 2,554 people (total number of holdings in our portfolio) and decided to determine how our “Apple-person” would look like.

With an average human weight of about 150 pounds, the total weight of our gathering would be 150 x 2,554 = 383 thousand pounds. However, our “Apple-person”, at 4.5% of the total, would weigh like a very large African elephant, clocking in at a whopping 17 thousand pounds.

While having such “elephants” in a portfolio can be both a good and a bad thing, it is absolutely critical for investors to be at least aware of their potential existence.

Sources: etfdb.com, ishares.com, finance.yahoo.com