The Danger of Diversifying Without Really Diversifying

Like many investors, I'm a huge fan of exchange-traded funds (ETFs), particularly because they combine the best features of stocks and mutual funds. When I invest in a particular company, I own only its stock. When I invest in an ETF, I own a diversified portfolio of stocks from many companies. Buying an ETF is like buying a whole basket of high-performing investments, thereby diversifying my portfolio.

However, there's an inherent danger in believing that you're diversifying your portfolio simply by putting your money in ETFs.

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When diversified isn't diversified

Investing in multiple ETFs can create an illusion of diversification while leaving you with greater risk, unnecessary costs, and a portfolio that may be more complex but is not safer.

Here's why: The most popular ETFs may have different names, but that doesn't mean they have different holdings. In fact, you could purchase two or three different ETFs and barely get any diversification because each one holds overlapping stocks.

How overlapping happens

There are a few reasons different ETFs end up with the same underlying holdings:

• It's common for stock ETFs to track broad indexes listing the same companies at the top. For example, large U.S. technology companies often dominate multiple indexes.
• Along the same lines, sector or thematic ETFs, such as those focused on tech, healthcare, or innovation, often hold many of the same high-profile growth stocks.
• Even different types of stock funds with different labels can end up owning many of the same big, popular companies.

The key danger of overlapping

Let's say you're committed to diversifying your portfolio and decide the best way to do so is to buy the Vanguard S&P 500 ETF (NYSEMKT: VOO) and iShares Core S&P 500 ETF (NYSEMKT: IVV). You feel pretty good about it: The former holds 505 stocks, and the latter holds 504 (as of June 11).

There's a problem, though. Both ETFs track the S&P 500, and because they're tracking the same index, their top holdings -- including Nvidia, Apple, and Microsoft are identical.

Because ETF baskets and portfolios carry the same market and category risks as their underlying securities, overlapping holdings concentrate risk rather than spreading it.

How to protect yourself from overlapping

List each ETF you already own or plan to buy. You're going to want to look under the hood of each onr.

Next, check the top holdings of each ETF. In the example above, both ETFs follow the S&P 500 index. However, it's possible to overlap with ETFs that seem quite different. For example, an ETF following the S&P 500 index may list the same top holdings as a technology ETF.

Make it easy on yourself by using a tool. The ETF Research Center provides a fund overlap tool that lets you enter two ETFs and instantly see the percentage of holdings and weight they share. Your instinct to diversify your holdings is a wise one. However, to do it right, you'll want to ensure your investments don't overlap.

Dana George has positions in Apple. The Motley Fool has positions in and recommends Apple, Microsoft, Nvidia, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.