Key takeaways:

• Investors who hold multiple ETFs in their portfolios should be conscious of ‘ETF overlap’, a phenomenon where the funds provide duplicate exposure to the same, or substantially similar underlying holdings (or even investment theme).

• Duplicate ETF exposure may reduce diversification and increase concentration risk via overexposure to a specific investment theme or cohort, and in some circumstances it may even lead to an investor paying higher fees.

• To establish whether your portfolio features ETF overlap, examine the underlying holdings of each fund - to minimise overlap, consider ETFs that are complementary with one another courtesy of exposure related to geography, sector, asset class, or market capitalisation.

• Past performance is not an indicator of future performance. It is important to do your own research before investing.

It’s no secret that exchange-traded funds (ETFs) have become an integral part of investors' portfolios. Over recent years, the size of the Australian ETF market has swelled, surging past $250 billion in assets under management (AUM) earlier this year.

Thanks to the practicality of diversification via a single instrument, and low fees, ETFs have long been a favourite within the Selfwealth community. In fact, local ETFs account for 11 of the top 20 most held ASX securities by value on the platform. Amid their booming popularity, it is common to see multiple ETFs feature in an investment portfolio. This gives rise to a phenomenon dubbed ‘ETF overlap’. 

Today, we’re taking a look at this issue, the implications of duplicate ETF exposure, and how you can avoid this in your portfolio.

What is ETF overlap?

Put simply, ETF overlap occurs when a portfolio features duplicate exposure across the underlying holdings among the funds — often, unintentionally. 

When we refer to duplicate exposure, it doesn’t necessarily entail an exact match. Some overlap is inevitable. Instead, it refers to a situation where two or more funds feature substantially similar underlying holdings. One might argue that it also extends to ETFs that result in duplicate exposure to individual stocks already held in the portfolio.

Nevertheless, this phenomenon tends to occur because many ETFs track popular indices and sectors. As such, funds that target a particular theme, geography, or sector, will often feature the same shares.

Consider for a moment, the most popular ETFs in the Selfwealth community. The Vanguard Australian Shares Index ETF (ASX: VAS) is the most popular fund on the platform. It tracks the S&P/ASX 300 Index. On the other hand, the Betashares Australia 200 ETF (ASX: A200), ranked seventh, tracks the top 200 largest ASX-listed companies. An investor who holds both of these funds in their portfolio has duplicate exposure to a large quantity of underlying holdings.  

What are the implications of duplicate ETF exposure?

As noted earlier, in many cases ETF overlap might be considered inevitable. And it isn’t inherently bad. However, since many investors buy ETFs with a view to diversify their portfolio, it might be considered counterintuitive to this objective, depending on the allocations of said funds.

But the fact remains — if two or more ETFs in a portfolio feature lots of identical holdings, the performance of the portfolio will be more influenced by those shares. In effect, mitigating the influence of diversification, and increasing concentration risk.

Using our earlier example, a downturn in the ASX 200, which impacts A200, will almost certainly have a very strong correlation with the performance of the ASX 300, and VAS, given the two funds share 200 common securities. As such, the portfolio’s performance would be more heavily tied to this cohort of stocks, as opposed to an alternative ETF tracking international shares, other assets, or the All Ordinaries.

The same applies to duplicate exposure to sectors or industries. For example, if you hold the Betashares Nasdaq 100 ETF (ASX: NDQ), as well as the Global X FANG+ ETF (ASX: FANG), there would be significant ETF overlap due to the similarity among the top holdings of each fund — largely dominated by big tech. If you also held the iShares S&P 500 AUD ETF (ASX: IVV), there would be even more overlap.

And of course, another issue investors need to consider is that by holding funds with substantially similar holdings, they may be paying duplicate management fees for the same exposure. That’s because said fees will differ depending on the fund manager. More often than not, this is particularly relevant with thematic ETFs, which tend to charge higher management fees. Over time, fees can eat into returns.

In some instances, such as where an investor has given consideration to the weighting of the funds and their underlying holdings, to ensure they do not breach desired exposure, ETF overlap might not pose an issue. However, the above considerations should be taken into account, especially since ETF position sizes are likely to vary over time.

How to identify and avoid ETF overlap

As a starting point, identifying ETF overlap relies on understanding the underlying holdings in each ETF you hold. In some instances, the top securities will account for a significant portion of the fund’s net assets, while in other cases, there might be thousands of securities within a fund, and each position is relatively modest as a percentage of the fund’s total net assets.

This information will be available on the ETF provider’s website, and is generally updated regularly. Aside from the weighting of the top holdings in each fund — investors should examine the underlying index methodology to understand security weightings and selection — it may be useful to look at the sector and geographic allocations of each ETF.

In navigating ETF overlap, investors may wish to consider complementary ETFs aligned with the overall objectives of the portfolio. For example, an ETF that targets Australian securities, and another that targets international securities, might be seen as complementary for capital growth purposes. 

On the other hand, two funds from the same geography might lead to ETF overlap. This might also be the case where thematic ETFs are held. For example, a mining fund and an ASX-oriented fund might lead to overlap due to the heavy cross-exposure of mining names within the broader ASX. Similarly, a technology ETF might lead to overlap when accompanying a US index fund.

Another way to tackle ETF overlap is to give consideration to the target market capitalisation of the underlying securities in a fund. There are various ETFs that offer targeted exposure to small-cap shares, which may help aid portfolio diversification if you hold another ETF that is largely influenced, or wholly consists of large-cap companies. 

By the same token, different asset classes can serve different investment goals, so an ETF focusing on fixed income, like bonds, would avoid unnecessary duplication and aid diversification purposes. 

Regardless of which ETFs you invest in, it is just as important to periodically review your portfolio to ensure it remains aligned with your investment goals and risk tolerance. Where it falls outside these parameters, including duplicate ETF exposure, rebalancing should be considered.

Building your portfolio

Although easily overlooked, ETF overlap has the potential to undermine one of the very benefits associated with exchange-traded funds — diversification. That’s because duplicate exposure to ETFs with largely similar underlying holdings can lead to concentration risk, impact the risk profile of your portfolio, and may even result in higher management fees. The key to tackle this phenomenon is to do your due diligence when investing in ETFs, ensuring you are building a diversified portfolio through complementary funds by way of their geographic, sector, market capitalisation, or asset class exposure.