How to avoid overlap in your ETF portfolio

Nobel prize-winner, Harry Markowitz, famously quipped, "Diversification is the only free lunch in investing". And he's right. Diversification across stocks, sectors, countries and asset classes lowers an investor's risk, while still providing good long-term returns. 

However, one risk that some investors may not be aware of is overlap. This occurs when an investor holds the same or similar stocks across their portfolio, thus lowering diversification and increasing risk. 

Overlap in a portfolio 

Here's an example of a fictitious portfolio, that may appear well diversified, but contains plenty of overlap, particularly in Big Tech.  

In this example, I count Big Tech as including Microsoft, NVIDIA, Apple, Alphabet, Amazon and Meta Platforms. 

By multiplying out the percentages across each position, and then adding them together, we can calculate that Microsoft makes up 10.15% of the overall portfolio and Big Tech (which includes Microsoft) makes up 29.81% of the overall portfolio. 

As we can see, the above portfolio has considerable overlap in Big Tech and to a lesser extent Microsoft. If we subtract the individual 5% holding of Microsoft, the concentration in Big Tech is still high. 

Unsurprisingly, the above portfolio would have performed very well over the past 10 years, however, we never know when the investment pendulum in Big Tech will turn. 

One good aspect to the above portfolio is the way that an ASX ETF has been combined with international ETFs to increase diversification. However, further improvements could be made. 

For instance, diversification could be improved by removing the individual Microsoft stock (as it is well represented elsewhere), and adding new asset classes such as bonds, property and infrastructure.  

Diversification can also be increased by swapping out iShares Global 100 ETF (ASX: IOO) which contains 100 stocks, for Vanguard MSCI Index International Shares ETF (ASX: VGS) which contains 1500 stocks from 23 countries. 

As always, constructing a portfolio and its weightings will depend on an investor's risk profile. 

One of the most difficult psychological struggles for investors is that there is a tendency to only want to own winners, which are often deemed to be the stocks that have done well recently. Over time, however, this can lead to a lopsided portfolio that doesn't fully protect you when markets turn. 

That is why it's good to own different asset classes that do well under different conditions. 

ASX-based indices 

In Australia, we also have to be cognisant of overlap between ETFs that are based on various broad-based ASX indices such as the S&P/ASX 200. 

Due to the dominance of the bigger companies such as BHP, CSL and the big banks, ETFs based on these ASX indices that are weighted by market capitalisation, are often very similar. 

For example, the Vanguard Australian Share Index ETF (ASX: VAS) is based on the ASX 300, but 97% of the ETF is comprised of 200 stocks, with just 3% of the ETF made up of the smallest 100 stocks. 

Hence, adding VAS to a portfolio that contains say just iShares Core S&P/ASX 200 ETF (ASX: IOZ), which is based on the ASX 200, will provide little in the way of additional diversification. 

How to know if overlap is a problem

Firstly, if there is minimal overlap in your portfolio then overlap is not an issue. Additionally, if there is some overlap that you are aware of and are happy with, then that too is fine, as sometimes we need to mix and match ETFs to get the exposures we want. 

The problem comes when you have lots of ETFs, funds and stocks, and you're not totally sure of how exposed you are to any one share, sector or country. 

Opinions vary of course, but as a guide, some investors say that a stock shouldn't be more than 5% of your overall portfolio. You should also be careful not to be overexposed to any one sector or theme. 

For instance, in 2022, the thematic-based ARK Innovation ETF, dropped 66% when all of its stocks went south at the same time, as interest rates rose, and unprofitable tech stocks were sold off. 

How to work out if there is overlap in your portfolio 

The first step to knowing whether you have an overlap problem, is by looking under the hood at each of your ETFs or managed funds. 

The best place to start is by looking at the product provider's website and examining the specifics of the ETF including the number of holdings and which sectors and countries are represented. 

The next step is to view the individual holdings in the ETFs, for example the top 20, and the percentage of each holding. The website will also show a breakdown of the ETF by sector. 

Do this for all of your ETFs and managed funds to see where overlap exists across your portfolio. Ensure that the combined stock and sector weightings are within the limits you prefer. 

Tips for overcoming overlap 

Here are four ways you can overcome overlap in your ETF portfolio: 

1. Know your portfolio. Go to the websites of your product providers and examine the breakdown of the holdings within each ETF. 
2. Keep it simple. A simpler portfolio is easier to manage. Make sure that each ETF has a particular purpose in the portfolio. 
3. Understand that there are little diversification benefits by adding ETFs that are based on similar indices. 
4. Ensure your portfolio is diversified across multiple asset classes including Australian shares, international shares, bonds, property, infrastructure and cash. 

Note: This article is for educational purposes and none of the ETFs mentioned in this article are recommendations.