Do You Really Know How Diversified Your ETF Is?

The Wrong Question About the Next Wave of IPOs

The next generation of mega-cap IPOs could have a larger impact on investor portfolios than many realize.

Much of the recent discussion surrounding companies such as SpaceX, OpenAI, Anthropic, and others has focused on valuation. Investors debate whether these companies deserve trillion-dollar valuations and what their eventual public market prices might be.

I think investors may be asking the wrong question.

The better question is what happens to the ETFs millions of investors already own if companies of that size eventually become eligible for inclusion in major indexes.

Diversification Isn't Just About the Number of Holdings

Most investors think of the S&P 500 as the ultimate diversified portfolio. After all, it contains 500 companies representing a broad cross-section of the U.S. economy.

But diversification and the number of holdings are not necessarily the same thing.

Today, Nvidia, Apple, and Microsoft account for roughly 20% of the S&P 500.

Add Amazon, Alphabet, and Broadcom, and nearly 30% of the index is concentrated in just six companies.

The S&P 500 still owns 500 companies. Yet a significant portion of its performance is increasingly driven by a relatively small number of holdings.

In other words, investors often focus on how many stocks an ETF owns while overlooking how much influence a handful of those stocks have on portfolio performance.

What Happens When New Trillion-Dollar Companies Join the Index?

If several trillion-dollar companies eventually come public and become eligible for inclusion in major indexes, their addition could materially change the composition of many portfolios.

Market-cap weighted indexes allocate capital based on company size. As a result, a newly public company entering an index at a massive valuation could immediately become one of its largest holdings.

Because market-cap weighted indexes allocate more capital to larger companies, the addition of a new mega-cap company can increase concentration within the portfolio. As larger companies occupy a greater share of the index, the weight assigned to existing holdings is reduced.

The ETF may still own 500 stocks.

The ETF may still carry the same name.

But the portfolio underneath may be materially different.

The Hidden Impact of Market-Cap Weighting

This issue isn't limited to one company or one IPO. It is a natural consequence of how market-cap weighted indexes are designed.

Many investors assume diversification rules prevent concentration risk from becoming significant. While tax and regulatory requirements place limits on portfolio construction, they do not necessarily prevent a small number of holdings from driving a large percentage of returns.

A fund can be diversified from a regulatory standpoint while still be concentrated from an investment standpoint.

Index construction matters.

It affects portfolio composition, concentration levels, and ultimately investor exposure.

Investors Have More Choices Than They Realize

Fortunately, investors have choices.

Those concerned about concentration risk are not limited to traditional market-cap weighted indexes. Equal-weight ETFs allocate similar weights across constituents rather than allowing the largest companies to dominate the portfolio. Other ETFs employ position caps, sector constraints, factor methodologies, or active management approaches designed to reduce concentration.

None of these approaches is inherently better or worse than market-cap weighting.

Each comes with its own advantages, disadvantages, risks, and tradeoffs.

The important point is that investors should understand the structure they own and determine whether it still aligns with their investment objectives.

Why Concentration Risk Matters

Periods of strong appreciation are often followed by periods of consolidation, correction, or increased volatility. As concentration levels increase, those periods of volatility can become more pronounced because a small number of holdings exert a greater influence on overall index performance.

ETF investors often focus on how much volume an ETF trades. Far fewer spend time understanding how index methodology, rebalances, and portfolio construction decisions can affect the risks embedded inside the fund itself.

A Reminder, Not a Prediction

This is not a prediction of a market decline.

Nor is it an argument against innovation, technology companies, or future IPOs.

It is simply a reminder that concentration risk exists, and that many investors may be taking on more of it than they realize.

Understanding What You Really Own

Investors spend a great deal of time researching individual stocks.

Far fewer spend time understanding the methodology governing the ETFs they own.

Yet those methodologies determine which securities are added, how they are weighted, and how much influence they ultimately have on portfolio performance.

The Key Question Every ETF Investor Should Ask

The lesson is simple:

Don't just ask what your ETF owns today.

Ask what it may own tomorrow.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.