What Long-Term Investors Should Know Before Buying This Broad Market ETF

The Vanguard Total Stock Market ETF (NYSEMKT: VTI) owns roughly 3,500 U.S. stocks. That sounds like strong diversification for a single fund. It isn't.

The problem exists with the top-heavy concentration at the top of the portfolio. The fund's top three holdings are Nvidia, Apple, and Microsoft. Combined, they account for 17% of the fund's assets. Top-10 holdings account for 32%. That's a lot of influence from just a handful of stocks.

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This is a consistent problem that occurs in almost any exchange-traded fund (ETF) that weights its holdings by market cap. In any S&P 500 fund, such as the Vanguard S&P 500 ETF, between 30% and 40% of the portfolio is in less than a dozen stocks.

It gets worse in sector funds. The VanEck Semiconductor ETF has nearly 50% of its portfolio in just five stocks: Nvidia, Taiwan Semiconductor Manufacturing, Broadcom, Intel, and Advanced Micro Devices. The State Street Energy Select SPDR ETF has 39% of its portfolio in just two stocks: ExxonMobil and Chevron.

True diversification doesn't come from the number of stocks in a portfolio. It depends on the weights of those components and how much idiosyncratic risk a fund exposes its shareholders to. If you're investing in a total market fund, odds are you're making a larger bet on fewer stocks. It's best to understand this before you dive in.

Before you buy stock in Vanguard Total Stock Market ETF, consider this:

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David Dierking has positions in Apple and Vanguard Total Stock Market ETF. The Motley Fool has positions in and recommends Advanced Micro Devices, Apple, Broadcom, Chevron, Intel, Microsoft, Nvidia, Taiwan Semiconductor Manufacturing, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.

What Long-Term Investors Should Know Before Buying This Broad Market ETF was originally published by The Motley Fool