This Popular Retirement ETF Has a Diversification Problem Investors Should Know About
Make sure you know where you're putting your money.
By Maurie Backman
If you're years away from retirement and are focused on building long-term wealth, chances are you've come across the Vanguard S&P 500 ETF (VOO 1.32%). It's one of the best-known exchange-traded funds on the market, and for good reason.
The Vanguard S&P 500 ETF makes investing for retirement simple. The fund simply tracks the S&P 500 index, which has long been considered a benchmark for the stock market as a whole.
The nice thing about investing your money in the Vanguard S&P 500 ETF is that you don't have to spend time researching individual stocks, monitoring earnings reports, and deciding when to buy or sell. Instead, you can buy shares of a single fund that gives you exposure to a broad range of companies. And since you're investing in the S&P 500, your money is going into established businesses -- not speculative ones.
In fact, legendary investor Warren Buffett has long said that for everyday investors, one of the best strategies is to simply buy low-cost S&P 500 index funds rather than try to pick individual winners. Most investors, Buffett argues, don't have the time, expertise, or interest required to consistently outperform the market, so there's no sense in trying to when options like the Vanguard S&P 500 ETF exist.
But while the Vanguard S&P 500 ETF certainly covers many segments of the market, investors who think they're getting a truly diverse mix of companies may not have the full story.
It's not as diverse as you'd expect
When you buy shares of an ETF that effectively gives you exposure to 500 different companies, it's natural to assume that you'll get instant diversification. But one thing to realize is that the Vanguard S&P 500 ETF is market-cap weighted, which means the companies with larger market caps get larger allocations. As a result, a small group of tech stocks has a huge influence on the fund's performance.
This doesn't mean that the Vanguard S&P 500 ETF is a tech ETF. But because tech companies now comprise such a large share of the S&P 500, by investing in the Vanguard S&P 500 ETF, you're putting a lot of money into tech, whether you realize it or not.
Now, if you're in the process of building wealth for retirement, that's not necessarily a terrible thing. During the wealth-building stage of your investing career, it's a good thing to focus on growth-oriented investments. And tech fits the bill. You can wait until retirement to chase stability and predictable income.
At the same time, it's important to understand the risks you may be taking on by putting your money into the Vanguard S&P 500 ETF. And it's also important to recognize that if the tech sector crashes, the value of your portfolio could plunge.
If you're years away from retirement, that's a pretty reasonable risk to take. The S&P 500 has gone through rocky periods before, and investors who stick with it in the long run tend to come out ahead. But it's important to understand what might happen if you load up on the Vanguard S&P 500 ETF and there's an adverse market event, particularly within the tech sector.
Always know what you're investing in
The Vanguard S&P 500 ETF remains one of the most effective tools for long-term investors. And Buffett's classic advice to rely on the S&P 500 isn't poor guidance by any means.
The point, rather, is that when you invest your money, it's important to have a clear understanding of the assets you own. You might think you're getting instant diversification with the Vanguard S&P 500 ETF when, in reality, you're getting a lot more exposure to the tech industry than you may be comfortable with.
Once you understand that, you'll be in a better position to decide whether the Vanguard S&P 500 ETF is right for you, or whether you're better off taking a different approach to building up your retirement savings.