ETFs are commonly marketed as an easy, low-cost way for investors to diversify.
However, Piper Sandler’s chief investment strategist flags a major risk for retail investors.
As market concentration reaches record highs, ETFs might be hurting your portfolio.
Buying an ETF is a common recommendation for investors looking for diversification, but the popular investment vehicle might not be doing the job you’re expecting it to, according to one Wall Street strategist.
Michael Kantrowitz, chief investment officer and head of portfolio strategy at Piper Sandler, isn’t a big fan of owning broad indices, especially in today’s highly concentrated market.
ETFs are supposed to put investing into easy mode, especially for retail investors. Anybody can purchase a basket of securities to diversify their portfolio — just pick a theme, buy the ticker, and wait. While they’re definitely a helpful tool for investors, Kantrowitz urges caution.
“By buying an index fund today, compared to 15 or 20 years ago, you’ve got a lot more idiosyncratic company-specific risk today,” Kantrowitz told Business Insider. “You think you’re buying an index, but you’re really just exposed to seven or 10 stocks. If the AI story takes a dip, it doesn’t necessarily hit all stocks, but it could really hit those index funds.”
Indeed, market concentration among the top Big Tech companies is at record highs. According to Apollo’s chief economist Torsten Sløk, the top 10 companies in the S&P 500 are trading at a higher valuation than that seen during the dot-com bubble. Investors who buy an S&P 500 fund for diversification are actually getting an over 30% weighting in the Magnificent Seven.
Additionally, using sector-specific ETFs to diversify isn’t always a good idea either, Kantrowitz added. ETFs can be susceptible to tracking error, meaning that the fund doesn’t precisely follow the underlying index.
SEC rules stipulate that no more than 25% of a diversified fund’s assets can be allocated to a single stock, which often forces sector ETFs to cap their exposure to dominant names like Apple or Nvidia, even if those companies make up a much larger share of the actual index.
For example, in 2024 the S&P 500 technology sector posted a 38% gain. However, the Technology Select SPDR Fund (XLK) only rose 25%.
This pattern is especially prominent in sectors with high concentration, which include communications services and consumer discretionary, Kantrowitz said.
“Because there are concentration issues and weighting schemes in these ETFs, you think you’re buying something and it’s actually not what you’re getting,” he said.
That doesn’t mean all ETFs are prone to this risk. Lean more into active management, Kantrowitz advises, including ETFs and mutual funds, as well as individual stock picks.
Kantrowitz also isn’t writing off large-cap quality stocks, such as some of the Big Tech names that have dominated the index. But if you’re looking for diversification, it’s a good idea to look outside of traditional index ETFs.
Read the original article on Business Insider
