This Is the Biggest Mistake Too Many Investors Make With an S&P 500 ETF

Key Points

• The Vanguard S&P 500 ETF and its peers are easy to understand, but newer investors often make a mistake with these funds.

• The mistake centers on perceived diversification.

• It’s a correctable error and boils down knowing what you own.

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Newer investors often hear about the virtues of diversification, while others are inclined to wait on stock picking until the foundation of their knowledge (and capital) grows. Those are among the reasons S&P 500 exchange-traded funds (ETFs) are so popular.

So popular that the three largest ETFs are all S&P 500 trackers. That group includes the Vanguard S&P 500 ETF (NYSEMKT: VOO), the world’s largest ETF. Another reason this ETF and its peers are so beloved is that some market participants believe these funds are diverse because they hold 506 stocks.

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S&P 500 ETFs aren’t as diverse as some investors assume. Image source: Getty Images

That’s a mistake, but it’s one that’s easily corrected. Here’s how investors can accomplish that objective.

Quantity doesn’t equal diversification

On the surface, any ETF holding 500-plus stocks appears to be diverse, but investors should not conflate quantity with diversity. Upon further examination, investors will discover that S&P 500 ETFs aren’t all that diverse. For example, as of June 30, the aforementioned Vanguard ETF allocated 38% of its roster to tech stocks.

That’s one sector out of 11 commanding 38% of the S&P 500, and just one other (financial services) garners a double-digit allocation.

The perceived lack of diversification with S&P 500 ETFs isn’t a knock on the funds themselves. Actually, it’s confirmation that these products are functioning as expected. The Vanguard S&P 500 ETF and its closest rivals are cap-weighted funds, meaning the holdings are weighted by market capitalization.

At the end of the second quarter, Nvidia was the largest holding in these funds. Cap-weighted funds tap into the market’s “collective wisdom.” If a diverse lineup results from that, great, but diversification isn’t necessarily a priority when weighting stocks by market value.

Investors can take another important step toward correcting the diversification assumption by doing a bit of homework to understand why some companies are added to the S&P 500. Yes, sector balance is a priority, but S&P Dow Jones Indices is also trying to compile a gauge that’s representative of the U.S. economy at large. The economy is tech-heavy, hence the index’s significant exposure to that sector. Fifty years ago, the gauge’s largest sector exposure was to industrials.

Don’t expect overnight riches

In addition to the diversification assumption, another mistake made by novice investors with S&P 500 ETFs is assuming that these funds are a path to quick riches. That’s not the case.

To print large dollar amounts in short order with a basic S&P 500 ETF, an investor needs significant capital and/or to be wealthy in the first place, because the index simply isn’t designed to be a thrill ride from a return perspective. Since its launch in September 2010, the Vanguard S&P 500 ETF has produced average annual returns of nearly 15% when accounting for reinvested dividends.

If that history repeats, it’s all the more attractive because the ETF’s yearly expense ratio is just 0.03%, or $3 on a $10,000 investment, making it one of the least expensive ETFs on the market.

Roughly 15% a year isn’t something to scoff at, but it’s not a recipe for instant millionaire-maker status. S&P 500 ETF investors should keep that perspective to avoid disappointment.

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Todd Shriber has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Nvidia and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.