Investors can track broad market moves with index-based exchange traded funds, but many follow traditional market capitalization-weighted methodologies, which may expose people to certain risks.
“There is an underlying issue with these products investors may not recognize: They think all broad-based core ETFs give a diversified representation of the market. Instead, they are often riding the fortunes of a handful of stocks,” writes Rick Genoni, head of the ETF business at Legg Mason, for InvestmentNews.
Specifically, capitalization-weighted indices put a heavy emphasis on the largest stocks, investors will typically overweight those companies that have been outperforming. For instance, when optimistic investors pushed Japanese equities higher than the rest of the world in 1980s, the weight of Japan in the MSCI World Index jumped from 10% in 1985 to 35% in 1989, which caused many investors in the market-cap-weighted index to experience steep losses in the following decade-long correction due to their over exposure.
“Over time, indexes become increasingly overweighted toward what has already done well,” Genoni added. “This means investors may have less exposure to what may be about to do well. It also amplifies the impact of individual stocks on the major cap-weighted indexes, which may add to overall volatility in the short term.”
Many broad cap-weighted index ETFs are top heavy. For instance, Apple (NasdaqGS: AAPL) and Microsoft (NasdaqGS: MSFT) make up large positions in the SPDR S&P 500 ETF (NYSEArca: SPY) and PowerShares QQQ (NasdaqGM: QQQ). SPY includes 3.8% AAPL and 2.0% MSFT. QQQ holds 13.3% AAPL and 7.1% MSFT. [Not All S&P 500 ETFs are the Same]
Alternatively, investors can gain market exposure through a range of factor-based, or smart-beta, ETFs that focus on specific characteristics to help diversify an investment portfolio.