Avoid This Hidden Risk of Index Funds

Index funds are a popular investment tool. In fact, it's possible to build an entire portfolio with index funds alone. However, that doesn't mean they're without risk.

If you own multiple index funds, you may be overlooking a hidden risk: Overlapping. It's important to understand what overlap is and how to avoid it when creating a diversified portfolio.

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What is overlapping?

Overlapping occurs when multiple index funds hold the same securities. Let's say you own the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) and the iShares Core S&P 500 ETF (NYSEMKT: IVV) -- both tracking the S&P 500. Naturally, they're going to include many of the same stocks. So, if the top five holdings are all AI stocks, you're going to have the same stock in multiple positions.

Overlapping is a common mistake, and one that's easy to understand. After all, index funds provide instant diversification by providing hundreds or thousands of different stocks. Thanks to overlap, that's where things can get tricky.

There are two types of overlap:

1. Stock overlap: When the same individual stock appears in multiple funds.
2. Sector overlap: When multiple funds are weighted heavily toward the same specific sector, such as IT, real estate, or healthcare.

At the root of the issue

The problem isn't that you've included more than one index fund in your portfolio. The problem is that, since they're tracking the very same index, you may not need more than one to accomplish your goals.

If it's diversification you seek, overlapping can be avoided to some degree by branching out. For example, if you invest in a broad-market index tracking primarily U.S. companies, your next investment may be an index fund that tracks international or emerging markets. While there may still be areas of overlap, they're likely to be minimal and easy to recognize.

Risks of overlapping

While investing in index funds remains one of the most attractive ways to steadily build wealth, real-world issues arise when one overlaps with another. For example:

• Lack of diversification: As mentioned, high overlap can reduce the benefits of diversification, as you may not be as exposed to the variety of sectors and asset classes as you want.
• Increased exposure to risks: Overlapping can increase your portfolio's exposure to risks associated with specific stock types or sectors. For example, purchasing multiple funds that hold significant shares in a tech company can disproportionately affect your overall portfolio if that company experiences losses.

It's not only other index funds

It's important to consider how an index fund may overlap with other investments, too. For example, if you have an IRA, 401(k), or other retirement fund, you should know what's held in those accounts. It's likely that when you look, you'll find at least some overlap. The same is true of any individual stocks you've purchased.

The good news is this: There are plenty of overlap analysis tools you can use to evaluate the extent of overlap in your index funds. Typically, these tools require only the fund name. Almost immediately, the amount of overlap -- normally expressed as a percentage -- appears. That way, you know right off the bat if you're putting too many eggs in one basket.

Dana George has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.