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.
“We advocate against an overconcentration to market-cap-weighted ETFs: too many eggs in too few baskets,” Genoni said. “There are many products to consider including new, alternatively weighted strategies in ETF format that can better help investors achieve their objectives.”
Legg Mason could soon enter the ETF game with four smart-beta offerings. The money manager is current working on the the Legg Mason Developed ex-US Diversified Core ETF, Legg Mason Emerging Markets Diversified Core ETF, Legg Mason US Diversified Core ETF and Legg Mason Low Volatility High Dividend ETF. [Legg Mason Crafting Four Smart-Beta, Index-Based ETFs]
ETF investors also have a growing number of options to choose from. For example, single-factor strategies, like low-volatility, help tactical traders to tailor exposures and implement specific views or control portfolio exposure. Additionally, multi-factor strategies, such as those provided by Research Affiliates and its fundamental indices, provide a more broad or diversified approach. There are currently 494 enhanced index-based U.S.-listed ETFs with $230.7 billion in assets under management, according to XTF data. [Rapid Growth in the Smart-Beta Index ETF Space]
For more information on alternative index-based strategies, visit our smart-beta category.
Full disclosure: Tom Lydon’s clients own shares of QQQ.
Max Chen contributed to this article.