Try Fund Library Premium
For Free with a 30 day trial!
We have been witnessing a growing trend towards exchange traded funds (ETFs) that hold a concentrated basket of securities rather than a portfolio of securities that are properly diversified. It is not a surprising development since most of the financial industry is driven by trend-following marketing departments rather than academically supported investment metrics.
Concentrated ETFs fit the style of retail investors seeking short-term lottery-style returns. The shorter the timeline, the better. Buying an ETF that manages a small basket of hot stocks – or just one stock – is more exciting than holding a passive index fund that owns every stock in the market. It is also a lot riskier.
The change is palpable. In the late ’90s about 85% of stock-index funds were weighted by capitalization, where larger companies carried greater weight, in much the same way as they do in the S&P 500 Index or the S&P TSX 60 Index. By the end of 2024, only 40% of index funds were capitalization weighted. The typical index fund held 503 stocks in 1998; by the end of May 2025, the number had declined to 123 stocks.
The downsizing strategy is expanding as big investment houses are marketing a slew of new concentrated ETFs holding fewer stocks. In some cases building an ETF strategy around a single stock.
It is a strange twist from a couple of perspectives. Obviously, investors are taking more risk, but more concerning is that many do not fully understand just how much extra risk is associated in a non-diversified portfolio. Ironically, concentrated ETFs are multiplying at a time when many investors worry about the tech-heavy (i.e., magnificent seven stocks) concentration in broad based indexes like the S&P 500.
You can’t dispute the mountain of academic research that supports the value proposition of proper diversification. Simply stated; attaching an ETF wrapper around a small basket of stocks doesn’t make it safe.
It can also distort the investor’s returns relative to market trends. The smaller the collection, the farther away from the overall market you move, leading to more extreme returns both up and down.
Historically, between 1985 and 2024, the average stock suffered at a point in time a maximum drawdown of 81%. More than half of those stocks never fully recovered. The fallout can be decimating for an investor’s financial plan.
Simply stated, fund managers want to earn higher fees. Whereas passive index funds charge 10 basis points or less to track a broad-based index like the S&P 500. Managers can earn 20 to 30 times that amount by managing a concentrated fund even if it is designed to track a specific index or small basket of stocks. And this is appealing to investors who want the rush that comes from chasing higher returns with greater risk.
Based on data from The Wall Street Journal (WSJ), we now have ETFs that capture the returns of heating, ventilation and air-conditioning stocks; own convertible bonds issued by companies that hold Bitcoin in their corporate treasury; use borrowed money to buy already leveraged loans; follow an index of small-to-midsize uranium stocks; track the future cost of transporting crude oil by sea; and replicate the performance of Icelandic stocks.
The ultimate in concentration risk is leveraged single-stock ETFs. They typically seek to double or triple the daily performance of only one stock. (A few aim to amplify the opposite of its return each day.)
When magnificent seven funds rolled out in 2022, they jacked up the returns with positions in Apple, Microsoft, or Tesla. More recently, in the search for outsized returns, investment houses have gone down the capitalization scale towards smaller more volatile stocks with a good story.
According to the WSJ, recently launched ETFs seek to double the daily returns of such tiny, hyper-risky stocks as electric-aircraft maker Archer Aviation, computing provider D-Wave Quantum, nuclear-power developer Oklo, voice-recognition company SoundHound AI, and lending platform Upstart Holdings. Among this list of single-company ETFs investors have been exposed to gains of 226% and losses of 26%.
So far, this risk-based strategy constitutes less than 0.2% of total ETF assets. But their average daily trading volume has more than doubled in the past year, to nearly US$9 billion.
We believe there are simply too many horror stories to justify exposing clients to these risks. We note for example; ETFs linked to the performance of cannabis stocks that lost more than 90% of their value between 2019 and 2023. ETFs following solar-stock indexes have fallen more than 70% at least three times. Index funds that use such factors as equal weighting (tilting toward smaller stocks) or momentum (rapid price appreciation) have suffered deeper drops than the overall market.
Nevertheless, money keeps pouring into quirkier index funds. Last year, US$132 billion went into non-market-capitalization-weighted index funds, according to Morningstar. Another US$25 billion flowed in during the first five months of 2025.
When you buy a narrowly focused ETF, you’re making an active bet on the direction of a particular market or asset, which by any definition is speculative. Unlike many other pleasures, speculation isn’t illegal, immoral, or even fattening. It can be educational, engaging, and just plain fun…as long as the profits last!
Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.
Disclaimers
Content © 2025 by R.N. Croft Financial Group Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.
Image: iStock.com/Alexandra Scott
Try Fund Library Premium
For Free with a 30 day trial!
Fund Library
