How ETFs Can Diminish Your Market Risk

Investors can utilize a growing number of exchange traded funds that implement alternative indexing methodologies to diminish market risks and potential limit the impact of another bubble.

James Norman, president of QS Investors, a Legg Mason affiliate, explains how market inefficiencies may lead to increased risk in the markets.

“An example of market inefficiency is the herding of investors that causes the formation of bubbles,” Norman wrote for InvestmentNews. “We like to say that history does not repeat itself in financial markets – but it does rhyme. Bubbles are easier seen in hindsight, but all are characterized by excessive differences between price and value; resistance to corrections; mania and herding behavior; and painful crashes.”

Factors that contribute to bubbles include more money, information and hype, according to Norman. For instance, larger pools of money moving together can cause some parts of the market to grow overvalued and cause some areas to appear undervalue. With more information, investors can learn about the next hot area or them and chase after it. Hot investments are quickly disseminated, which may further fuel the fire.

Alternatively, investors may turn to diversified ETFs that could provide better risk-adjusted returns over the long-term.

“ETFs can help, specifically those not tied to market-cap indexes,” Norman added. “ETFs that focus on specific sectors, industries or countries can help mitigate the impact of bubbles when they burst, largely by avoiding market concentration risk (their exposure to which many holders of market-cap-weighted ETFs are only now fully realizing).”

Specifically, the strategist pointed to low-volatility and high-dividend ETFs can better manage risk and take advantage of human behavior.