Always read the ingredients label

Oct 26, 2006 by

Many people won’t buy a box of cereal without looking at the ingredients. When investing in diversified assets, the same strategy should apply. Many Exchange-Traded Funds (ETFs) contain an amalgam of companies that does not mirror any major external index. Before investing in an ETF, you should examine both its major holdings and its sector weightings. By doing so, you can better tell what you are really getting yourself into. Some ETFs are far less diversified than you might imagine. Yahoo! Finance (http://finance.yahoo.com) provides detailed information on the holdings of ETFs.

Right after North Korea claimed that it had nuclear weaponry, one of my friends suggested investing in Samsung. Upon reading the holdings of the iShares MSCI South Korea Index (EWY), I realized that I was already heavily invested in the company, but did not realize it. Check out http://finance.yahoo.com/q/hl?s=EWY As you can see, EWY consists of 22.04% Samsung Electronics*. Thus each $100 investment in EWY is a $22.04 investment in Samsung. Following this logic, if Samsung went bankrupt for an idiosynchratic reason, and its stock plummeted to zero overnight, each $100 investment in EWY would be worth only $77.96 overnight. While many people think that ETFs provide lots of diversification and protect them from idiosynchratic risks, as is seen in the case of EWY, this is not always the case.

*Two digressions
1. Samsung is the largest company in Korea. If it tanked, the whole Korean economy would likely heavily suffer.
2. Samsung is a chaebol, a Korean conglomerate company. Samsung Electronics is only one division of The Samsung Group, which also contains companies in chemical industries, financial services, entertainment, etc. See http://en.wikipedia.org/wiki/Samsung for more details. Thus, EWY does not even provide investors with an investment in all of Samsung. Nonetheless, it performs well, and I hold it.

2 Comments

  1. jay

    It seems like with this post you are trying to get investors to take a closer look at ETFs before they invest in them. Which I agree is a great idea. But I believe you are being a little harsh on ETFs. While it is true that investing in EWY will not truly diversify your portfolio, there are many other ETFs that are out there that will do a much better job at helping make your portfolio more balanced.

  2. Swintah

    And don’t forget to keep an eye on it! The allocation will change with time, so you can’t buy and forget. It’s like having a pet – you gotta keep after it.

    BTW, I’m enjoying your site so far, and I’m looking forward to more.

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