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.
There are a number of options available to ETF investors. For instance, the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), which tracks the 100 least volatile stocks on the S&P 500, and the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), which selects stocks based on variances and correlations, along with other risk factors, are two popular low-volatility ETF plays. [Slow And Steady: ETF Strategies for a Volatile Market]
For dividend yield exposure, the Vanguard High Dividend Yield ETF (NYSEArca: VYM) has a 3.11% 12-month yield, iShares Core High Dividend ETF (NYSEArca: HDV) has a 3.76% 12-month yield and iShares Select Dividend ETF (NYSEArca: DVY) has a 3.28% 12-month yield. VYM selects stocks based on annual dividend yield forecasts, excluding more sensitive areas like real estate investment trusts, master limited partnerships and micro-caps. The portfolio includes a collection of large-cap heavy names with an above average yield. HDV also screens picks to account for financially healthy, high-quality U.S. companies with relatively high dividend payouts. DVY tracks 100 high-yielding U.S. stocks and weights components by dividend per share. [Where To Look In A Low-Yield Environment]
The recently launched e Compass EMP US Large Cap High Dividend 100 Volatility Weighted Index ETF (NasdaqGM: CDL) and the Compass EMP US Small Cap High Dividend 100 Volatility Weighted Index ETF (NasdaqGM: CSB) combine the two themes. [Compass Expands ETF Lineup With Three New Funds]
While Legg Mason does not currently have any ETFs available, the money manager is working on a number of smart-beta index-based ETFs, including 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]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.