Index funds are supposed to make investing easy. Pick a broad fund, keep buying it and let the market do its thing.
But how diversified is that fund really?
That’s the question Tash and Jack get into in this episode of the Get Rich Slow Club. Because while an index fund might hold hundreds or even thousands of companies, those companies aren’t necessarily getting an equal share of your money.
The diversification illusion
Take the S&P 500. There are 500 companies in it, so it sounds pretty well spread out. But the companies aren’t equally weighted. The biggest businesses take up a much larger share of the index, which means their performance has a bigger effect on your investment.
Jack points to the so-called Magnificent Seven as an example. Companies including Apple, Amazon, Tesla and Meta make up a surprisingly large chunk of the S&P 500. In the episode, he puts the combined weighting of the seven at about a third of the index.
Tash admits she was surprised when she first realised just how concentrated the index had become. There’s nothing inherently wrong with that; the S&P 500 is doing exactly what it is designed to do. The thing to be aware of is that buying 500 companies doesn’t mean you’re getting 500 equal bets.
Jack also makes an important point: the companies dominating the index today won’t necessarily dominate it forever. If another group of businesses grows faster, those companies will become a bigger part of the index. You don’t have to predict which ones will take over. The index will adjust as the market changes.
Australia has a different problem
The Australian market has its own concentration issue, although technology isn’t the main culprit here. Our market is heavily dominated by financials and materials, which Jack says combined make up about half of the Australian market.
So if you buy an ASX 200 ETF, you are getting exposure to 200 companies, but a large chunk of that investment is still tied to banks and mining. Jack points out what that could mean in practice: a problem in the property market could affect the banks, while a slowdown in demand for Australian resources could hit the miners. That’s not an argument against owning an Australian index fund. It’s just worth knowing what you’re actually getting.
It also means that adding an Australian ETF to a portfolio that already has a lot of exposure to the local economy might not change the risk as much as you expect. If you own Australian shares through super, for example, buying another domestic index fund outside super is increasing an exposure you may already have.
Adding another ETF might not fix it
This is where things can get a little counterintuitive.
You might realise your portfolio is concentrated in one area and decide to buy another ETF to spread things around. But if that second fund owns many of the same companies, you haven’t necessarily diversified much at all.
Jack gives the example of someone who owns a broad global fund such as VGS and then adds a Nasdaq ETF. The Nasdaq holdings are already largely represented in the broader US market, so the second ETF can increase your exposure to those companies without adding much that is genuinely new.
Tash says she’s ended up with this kind of overlap herself. She has changed the ETFs she invests in over the years and now mainly buys DHHF. She says some asset overlap isn’t necessarily a problem, provided you understand what it’s doing to your portfolio.
Jack also points out that VGS, despite being a global share fund, has a large US weighting. That might sound like a lack of diversification on paper, but many of the biggest US-listed companies are global businesses themselves. Their customers aren’t confined to the country where they’re headquartered. So looking at the country label alone doesn’t always tell you how geographically exposed a fund really is.
That seems to be the bigger issue. It’s easy to look at a portfolio with five ETFs and assume it’s more diversified than one with a single fund. But you need to look inside the funds to know whether that’s actually true.
When passive investing gets less passive
There’s another problem with continually adding ETFs: at some point, you can end up managing your portfolio quite actively.
Jack talks about investors adding funds because they want exposure to whatever sector happens to be attracting attention. Maybe it’s AI. Maybe it’s uranium. Maybe it’s copper. That’s quite different from the original idea behind index investing, which is to buy a broad slice of the market and leave it alone.
Tash has fallen into this trap herself. She says she spent years trying to optimise her portfolio and bought some thematic ETFs along the way. Some of them didn’t work out particularly well. Eventually, she decided that constantly trying to improve the portfolio wasn’t necessarily helping.
Jack’s view is similar. For most people, he says, one well-diversified fund that suits their circumstances may be enough. There can be a place for a smaller complementary fund, but continually picking and choosing ETFs adds complexity without necessarily giving you much more diversification.
There’s also a timing issue. Jack says that when he worked as an adviser, he often saw people asking about an asset or sector after it had already had a strong run. Gold would take off and suddenly everyone wanted to know whether they should own gold. A particular part of the market would surge and investors would want to add an ETF covering it. By that point, some of the gains that attracted their attention had already happened.
That doesn’t mean an investment can’t continue rising. It just highlights how easily “diversifying” can turn into chasing whatever has recently done well.
What about the big tech companies?
The concentration in the S&P 500 also raises a more obvious question: are investors taking too much of a punt on big US technology companies?
Jack thinks it’s something worth considering, particularly given how much money has been flowing into the sector. But he also points out that today’s biggest tech companies aren’t quite like the businesses that made up the dot-com bubble. Companies such as Apple and Nvidia have substantial revenues and profits.
He also discusses an argument from Vanguard’s chief economist that the companies providing new technology don’t necessarily end up being the biggest beneficiaries over the long term. With AI, for example, there could eventually be more value created by businesses that use the technology to become more efficient than by the companies building the technology itself. It’s an interesting reason not to assume today’s dominant sector will always be tomorrow’s dominant sector.
And again, that’s part of what an index gives you. If the market changes, the index changes with it.
So how many ETFs do you need?
Probably fewer than you think. If you already have a broad fund containing thousands of companies, adding another broad fund isn’t necessarily going to make you much more diversified.
Before buying another ETF, it’s worth looking at what you already own. Check the biggest holdings and see whether the new fund is actually giving you something different. You might find that it fills a gap, or you might find that you’re buying a lot of the same companies again.
That doesn’t mean you can never have more than one ETF. Jack says there can be a place for smaller funds that give you exposure to something your main fund doesn’t cover. But for most people, he thinks there’s little point constantly trying to optimise the portfolio.
That was probably the most useful part of the conversation. An ETF can contain hundreds or thousands of companies and still leave you with a lot of exposure to a handful of them. And adding more ETFs doesn’t automatically solve that. Sometimes, you really don’t need another fund.
You can listen to the episode in full here.
If you enjoyed the episode, you can follow the Get Rich Slow Club and find Tash and Ana on Instagram at @tashinvests and @anakresina.
Disclaimer: This article is general in nature and doesn’t take into account your personal financial situation, needs or objectives. It isn’t financial or tax advice, and shouldn’t be relied on as a recommendation to buy, hold or sell any financial product. Before making any investment decision, consider whether it’s appropriate for your circumstances and consider seeking advice from a licensed financial adviser.
