Many of the largest and most popular exchange traded funds follow traditional beta-indexing methodologies that emphasize large-capitalization stocks. However, investing based on market capitalization may not be the most optimal strategy.
Market-cap weighting generates returns from investing in a portfolio based on price where the largest companies have the biggest effect on overall returns.
“It turns out historically market-cap weighting has been a very suboptimal way to invest as it overweights expensive markets and bubbles,” Mebane T. Faber, Chief Investment Officer and Portfolio Manager of Cambria Investment Management, said in a Morningstar article.
For instance, in a global equity portfolio, Faber pointed out that an investor would have included 50% weight in Japan over the late 1980s during one of the largest bubbles we’ve ever seen.
Additionally, many investors allocate about 70% of the portfolio to the U.S., one of the most expensive markets. Investors who follow a Boglehead/indexing model should have at least half of their portfolio invested in overseas assets.
“We believe it is more reasonable to weight markets and companies by value rather than price,” Faber said. “It is just as important to avoid what is expensive as to invest in what is cheapest.”
For example, the Cambria Global Value ETF (NYSEArca: GVAL) passively tracks the Cambria Global Value Index, which consists of stocks with strong value characteristics. Specifically, the ETF follows the top 25% of countries based on long0term valuation metrics, a CAPE ratio in the high single digits, top 30 stocks in each country by market cap and top 10 stocks across valuation composite, like price/sales, price/book and dividends. The fund’s holdings are also somewhat equally weighted. [An Active ETF That Targets Global Bargains]
“We think investors should be size-agnostic,” Faber added. “At some points in the business cycle, small caps can be a much better opportunity than large caps, and vice versa. Now is not one of those times in the U.S. for small caps, and most of the value we are finding is in mid-cap and large-cap stocks.”
GVAL’s market-cap allocations include mega-caps 14.9%, large-caps 23.6%, mid-caps 31.8%, small-caps 24.9% and micro-caps 4.8%. The ETF is up 6.1% over the past three months and comes with a 0.69% expense ratio.
For more information on index-based ETFs, visit our indexing category.
Max Chen contributed to this article.