The recent fallout in response to the United Kingdom’s referendum vote on breaking ties with the European Union revealed the potential pitfalls international stock exchange traded fund investors face as traditional market capitalization-weighted country and sector exposure may leave investors open to unnecessary risks.
“The Brexit shows the benefits of sector and country ETF diversification,” Michael J. LaBella, Portfolio Manager at QS Investors, told ETF Trends in a call.
The majority of exchange traded funds track traditional benchmark indices, which typically employ a market capitalization-weighted methodology where the largest companies have the biggest weights within the index. Consequently, in the case of international stock ETFs, these traditional market cap-weighted index funds may have large exposures to specific countries and sectors.
Related: 10 ETFs Hit the Hardest in ‘Brexit’ Fallout
The common use of investing based on capitalization-weighted indices may be flawed and potentially expose investors to unintended risks or to missed opportunities.
For instance, many have looked to the MSCI EAFE Index as the benchmark for global developed overseas exposure. The index tracks developed economies out of European, Australasia and Far East. However, the index and related funds that utilize the benchmark included a hefty 18.6% tilt toward the United Kingdom, the second largest country weight in the index, and a 22.2% position in financials.
“I think our topic for today’s call just became more obvious with Brexit,” Rick Genoni, Managing Director and Head of ETF Product Management at Legg Mason, said. “A very clear tie in to why macro diversification matters.”
Related: 12 Treasury Bond ETFs with Thrust as Brexit Uncertainty Extends
As we recently witnessed, British equities were among the worst performing global markets and financials were the worst performing sector in the wake of the Brexit fallout.
“Using conventional passive, index-based investing as the center of a balanced investment strategy can introduce unexpected – and unwanted – volatility into a supposedly conservative portfolio, at just the moment when investors may be seeking refuge,” according to Legg Mason