When an ASX investor buys an exchange-traded fund (ETF), one of the reasons you will probably hear is 'diversification'. Yes, index funds, in particular, can be enormously useful in diversifying a concentrated portfolio with one easy investment. Take the most popular index in the world, the US's S&P 500 Index. One unit of an S&P 500 ETF, such as the iShares S&P 500 ETF (ASX: IVV), represents an investment of roughly 500 of the largest companies on the US markets. You might think the same could be said of the Vanguard Australian Shares Index ETF (ASX: VAS).
VAS is the most popular ETF on our share market. It is an index fund that tracks the S&P/ASX 300 Index (ASX: XKO). This index, as you might imagine, tracks 300 of the largest ASX shares on our share market. Diversified, right?
Well, not as much as you'd think.
What's in an index?
See, an index fund is usually weighted by market capitalisation. That means that the largest companies on the index also have the largest weighting in the ETF. Woolworths Group Ltd (ASX: WOW) has a far larger presence in VAS than say IGA-owner Metcash Ltd (ASX: MTS), for example. This isn't a big deal, most index funds follow a similar arrangement.
Over time, it allows the winners in an index to contribute more to the index's overall performance. But in VAS's case, we have recently seen the fund become far more concentrated than it used to be. That's thanks in large part to BHP Group Ltd (ASX: BHP). Earlier this year, BHP ended its dual-listing structure, which saw its London Stock Exchange listing dissolved, and those shares return to the ASX boards. Thus, BHP is now a far larger company on the ASX than it used to be.
That means it's also a larger holding in VAS. As a matter of fact, as of 31 January, BHP alone made up 10.88% of VAS's entire portfolio.
Next up, we have Commonwealth Bank of Australia (ASX: CBA), with a 7.41% weighting.
CSL Limited (ASX: CSL) is next, worth 5.77%.
But National Australia Bank Ltd (ASX: NAB), Australia and New Zealand Banking Group Ltd (ASX: ANZ), and Westpac Banking Corp (ASX: WBC) were VAS's 4th, 5th and 6th most-weighted shares respectively. That's with a corresponding 4.12%, 3.47% and 3.45% weighting. And Macquarie Group Ltd (ASX: MQG) was the 7th, at 3.01%.
That's a total of 21.46% of VAS's total holdings for the big four and Macquarie alone. More than a fifth.
VAS-t diversification?
Throw in BHP's 10.88% and Rio Tinto Limited's (ASX: RIO) 1.92% and we have a total of 34.26% of VAS's total holdings in banks and miners. More than third.
So almost one dollar in every three invested in VAS goes to these two miners and five bank shares. That's not exactly what one might call a high level of diversification. And this diversification would deteriorate even further if an investor holding the Vanguard Australian Shares Index ETF in their portfolio also happened to hold any of those companies too.
Now, other index funds like the iShares S&P 500 ETF are also top heavy. But, by contrast, IVV's top holding is only worth 6.91% of the entire portfolio. That's a big difference from 10.88%.
That said, there's nothing inherently wrong with VAS's structure. That's how index funds are supposed to work. But just be wary of the kinds of diversification you are getting with an ASX index ETF. It might not be as diverse as you might think.
