Are ETFs still the low-risk investment that people think they are?

• Dominance of big tech stocks means spread of investments is not as diverse  

Nvidia shares dropped almost seven per cent on Wednesday on the back of its second quarter report, which, while stronger than expected, failed to live up to live up to the highest hopes as it only slightly beat estimates.

The chip maker's value is already on the mend, and this fall appears only to have been a momentary blip. 

However, with the S&P 500 having also fallen following Nvidia's results, eyebrows are raised when it comes to the weight that the top US tech stocks now hold in the market.

It might have also highlighted to some investors the importance of having a diversified portfolio.  

For many, the meteoric growth seen by Nvidia and the other constituents of the magnificent seven will have delivered massive returns.

But not all investors are keen to throw their lot in with the fortunes of such a small sect, with diversification proving an established tenet of investing for most shrewd long-term investors.

Many investors look to exchange traded funds, or ETFs, as a way to easily diversify their portfolios by buying into a bundle of stocks in one transaction.

What is an ETF, and what are the benefits?  

Being made up of a number of assets, low cost due to their passive nature and very flexible, ETFs are often popular with investors who want to keep their costs down while still diversifying.

ETFs work by tracking a certain pool of stocks, and can be traded on an exchange in the same way as an individual stock.

The aim of an ETF is to replicate the bundle of stocks it is tracking, which could be anything from a stock market index to bonds, commodities or a specific sector.

For example, investors can find ETFs that track the S&P 500 or FTSE 100, or could be more specific with those tracking consumer staples or metals & mining.

As a result of being passive investments, ETF fees tend to be far lower than those of actively managed funds.

How risky are ETFs?  

Traditionally, ETFs have been viewed as a relatively low-risk investment due to the spread they offer. 

However, with the rise of the US tech sector, ETFs could prove somewhat riskier an investment than they might have been previously.

Etoro market analyst Sam North says: 'While the ETF itself hasn't altered, its risk profile may have evolved. 

'As a result, one could argue that it's not the "same product" in terms of risk exposure. The ETF continues to track the S&P 500, but what that index represents in terms of market sectors and company sizes has evolved over time.

'This change may mean that the ETF no longer offers the same broad market exposure it once did, largely due to the increased concentration in tech and other mega-cap stocks.'

What is happening to US tech stocks, and what does this mean for ETFs?

The past year has seen the US' top tech stocks experience huge increases in value. 

The magnificent seven: Apple, Tesla, Meta, Alphabet, Amazon, Microsoft and Nvidia, have all been on the rise, with AI having accelerated the surge.

Over the course of the past year, at lot of what would historically have been thought of as low-risk, passive tracker funds have seen their weightings change significantly  Rob Burgeman 

Due to their success, these firms now massively outweigh each of the 493 other companies in the S&P 500. This has meant a good year for the index, but as seen over the past few days, it also means that the market is tied to the fortunes of these few companies.

Of the iShares Core S&P 500 ETF 503 holdings, the top 10 stocks (seven of which are the mag seven, with the remainder being Eli Lilly, Berkshire Hathaway and Broadcom) now account for 34 per cent of the value of the overall portfolio, data from Brewin Dolphin reveals.

The magnificent seven account alone for almost 31 per cent of the ETF, while in total the tracker has 41 per cent exposure to the tech sector.

The over-exposure to the tech sector is an even greater problem for Nasdaq-linked ETFs, with the index's tech bias making it far more reliant on the sector, while its lower number of constituents worsens the issue.

The iShares Nasdaq 100 ETF's top ten stocks, which includes each of the magnificent seven firms, accounts for just over 50 per cent of the total portfolio, with Apple making up 9.3 per cent alone.

According to Brewin Dolphin, this problem extends beyond US-based ETFs, with the iShares core MSCI World ETF having its top ten holdings accounting for 17.5 per cent of portfolio, despite holding a total of 1,431 companies.

Of these ten, Apple, Nvidia, Microsoft, Amazon and Meta are all constituents.

Rob Burgeman, senior investment manager at RBC Brewin Dolphin, says: 'Over the course of the past year, at lot of what would historically have been thought of as low-risk, passive tracker funds have seen their weightings change significantly. 

'With a lot of them now highly exposed to six or seven companies, in particular, it means the returns they have generated are not really what we would think of as low-risk.

'You need to be aware of the risks you're taking as an investor, so you shouldn't necessarily invest in a tracker fund because you have assumed it will be low risk. 

'If a fund has up to 50 per cent exposure to just 10 companies, that is a high degree of concentration – one that, broadly speaking, typically wouldn't be allowed in many actively managed funds.'

What are the alternatives to ETFs?

With the surge in the value of tech stocks, has come a rise in 'equal weight' index trackers, which offer the same portfolio companies but lack the overweighting of certain stocks due to their value.

While this does reduce investors' exposure to a small number of firms, it also reduces their ability to benefit from these companies growing rapidly.

For example, the iShares S&P 500 Equal Weight ETF returned 11.7 per cent in 2023, compared to 26.3 per cent for the unequal ETF.

'As with anything, there is a time and a place where an equal-weight ETF is more favourable,' Sam North says. 

'For example, in a period when you think there might be rotation from big-tech companies to other areas of the market, then the equal-weight S&P 500 ETF might make more sense.

'Investors who are concerned about the now very high valuations of these stocks – which have led to a major disparity with the other 493 stocks – might look to the equal-weight ETF to mitigate the risks associated with the heavy concentration in these tech giants.'

Meanwhile, for those who do want to expose themselves to these tech firms, there are ETFs that deal specifically with the sector.

For example, investors could choose the Roundhill Magnificent Seven ETF, or instead pick a slightly broader tech tracker such as the iShares Semiconductor ETF which invests in 35 firms.

There is also a chance that the Magnificent Seven's share of these ETFs might be beginning to wane as other stocks begin to deliver, especially with US interest rate cuts looking increasingly likely, according to Lindsay James, investment strategist at Quilter Investors.

She says: 'With interest rate cuts in the US looking imminent, better performance from overlooked parts of the stock market also seems likely, meaning active fund managers can breathe a sigh of relief after a long period of dominance by the Magnificent Seven, which may now be coming to an end.'