In a market downturn, traditional beta indices can suffer as their  market capitalization weighting methodology leans toward the best performers. Alternatively, exchange traded fund investors may turn to factor-based or smart-beta indexing strategies to potentially diversify the risks.

“The end of a market bubble is never pleasant, but it can be especially painful for investors in passive strategies that track major stock indexes,” according to Legg Mason. “A key reason: those indexes tend to increase the weighting of rapidly rising sectors as bubbles inflate, setting up investors for a bigger fall.”

Typically as sector bubbles deflate, their weights will drag down broader market cap-weighted indices, especially after investors’ tendency to herd toward supposedly hot areas.

“Using conventional passive, index-based investing as the center of a balanced investment strategy can introduce unexpected – and unwanted – volatility into a supposedly conservative portfolio, at just the moment when investors may be seeking refuge,” according to Legg Mason.

Alternatively, ETF investors can turn to enhanced or smart-beta index options. For instance, Legg Mason recently launched the Legg Mason US Diversified Core ETF (NasdaqGM: UDBI), Legg Mason Developed Ex-US Diversified Core ETF (NasdaqGM: DDBI) and Legg Mason Emerging Markets Diversified Core ETF (NasdaqGM: EDBI).

Through a partnership with QS Investors, the three funds take a macro, top-down approach that help balance risk to deliver broad market exposure through QS Investors’ proprietary Diversification Based Investing (DBI) rules-based methodology. QS Investors has provided custom solutions for institutional and pension funds for 15 years.

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