Exchange-traded funds (ETFs) and index funds have become the go-to investment vehicles for millions of investors looking for simple, low-cost diversification. The idea is simple: instead of picking individual stocks, you invest in a basket of securities that mirrors a market index, reducing risk while capturing broad market returns.
But is investing in an ETF or index fund really giving you true diversification and wide exposure, or are there hidden risks that most investors overlook? While these funds offer broad market access, not all ETFs and index funds are created equal, and some may not be as diversified as they appear.
The Illusion of Diversification: Are You Really Spread Across Many Assets?
Diversification is one of the core principles of risk management. The idea is that by spreading investments across multiple assets, industries, and regions, you reduce the impact of a single stock or sector collapsing. ETFs and index funds seem to solve this problem—after all, an S&P 500 ETF gives you exposure to 500 companies, right?
Yes, but here’s the catch: not all holdings in an index fund are weighted equally. Most ETFs and index funds are market-cap weighted, meaning larger companies make up a much bigger portion of the fund than smaller ones.
For example, in 2024, the top 10 stocks in the S&P 500 account for over 26% of the entire index. This means that even though you technically own 500 stocks in an S&P 500 ETF, your portfolio is still heavily concentrated in just a handful of companies like Apple, Microsoft, Amazon, and Nvidia.
| S&P 500 Top Holdings (February 2025) | Weight in Index |
|---|---|
| Apple (AAPL) | 7.4% |
| Nvidia (NVDA) | 6.3% |
| Microsoft (MSFT) | 5.9% |
| Amazon (AMZN) | 3.9% |
| Meta (META) | 2.9% |
So, while an S&P 500 ETF provides broad exposure, it’s not evenly diversified—a downturn in the tech sector could disproportionately impact the fund’s performance.
The Risk of Overlapping Holdings in ETFs
Many investors think they are diversifying by buying multiple ETFs—such as an S&P 500 ETF, a Nasdaq ETF, and a growth ETF. But in reality, these funds often hold the same stocks, leading to unintended concentration risk.
For example, let’s say you invest in:
- Vanguard S&P 500 ETF (VOO)
- Invesco QQQ ETF (Nasdaq 100)
- ARK Innovation ETF (ARKK)
Even though these ETFs track different indices, they all have heavy allocations to big tech stocks like Apple, Microsoft, and Nvidia. This means you aren’t as diversified as you think—you’re just increasing your exposure to the same companies.
The same issue arises with sector ETFs—many clean energy, AI, or fintech ETFs end up heavily concentrated in just a few dominant companies, reducing their diversification benefits.
Global Exposure? Not Always. The Hidden Home Bias of Index Funds
Another common assumption is that investing in a broad-market ETF gives you global diversification. But in reality, most U.S. index funds have a significant “home bias”, meaning they are overwhelmingly concentrated in American companies.
For example, the S&P 500 represents only U.S. companies, despite the fact that the U.S. makes up just 60% of the global stock market. Investors who only hold S&P 500 ETFs are missing out on significant international exposure, including emerging markets, European markets, and Asia-Pacific equities.
| Region | Share of Global Market Cap (2024) |
|---|---|
| United States | 60% |
| Europe | 15% |
| China | 10% |
| Japan | 6% |
| Emerging Markets | 9% |
To truly diversify geographically, investors should consider adding international ETFs, such as:
- Vanguard FTSE All-World ex-US ETF (VEU) – Covers developed and emerging markets outside the U.S.
- iShares MSCI Emerging Markets ETF (EEM) – Provides exposure to fast-growing economies like China, India, and Brazil.
Without international allocation, you are not truly diversified—you are simply betting on the U.S. market continuing to outperform.
The Right Way to Use ETFs for True Diversification
Despite these risks, ETFs and index funds remain some of the best investment tools available, as long as you use them correctly. Here’s how to maximize their diversification benefits:
- Mix Market-Cap Weighted and Equal-Weighted ETFs
- Instead of only investing in market-cap weighted funds (like VOO), consider equal-weighted ETFs (like RSP), which give each stock an equal allocation rather than overweighting the biggest companies.
- Include International Exposure
- A true diversified portfolio should have at least 20-30% in international stocks, reducing reliance on the U.S. market.
- Avoid Redundant ETFs
- Before buying multiple ETFs, check their top holdings to ensure you aren’t just doubling down on the same stocks.
- Blend Growth and Value Stocks
- Many ETFs are tech-heavy, but adding value-focused ETFs (like VTV or IWD) can provide stability in market downturns.
- Don’t Ignore Bonds and Alternative Assets
- Real diversification includes bonds, real estate, and even commodities, not just stocks. Consider ETFs that cover these assets for a balanced portfolio.
Are ETFs and Index Funds Still Worth It? Absolutely—But Be Smart About It
While ETFs and index funds offer an easy way to invest, they are not as diversified as many assume. Overweighting tech stocks, lacking global exposure, and overlapping holdings across multiple ETFs can create hidden risks that investors should be aware of.
However, by carefully selecting a mix of different ETFs across various asset classes and geographies, investors can truly achieve broad diversification and build a resilient, long-term portfolio.
The key is not just owning more stocks, but owning the right mix of assets—and understanding that diversification isn’t just about numbers, but about reducing concentrated risks and maximizing long-term returns.
