Smart-beta or alternative index-based exchange traded funds may help investors avoid risks associated with traditional beta indexing or a market capitalization-weighted methodology.
On the recent webcast, What is Smart Beta? Understanding the Next Generation of ETFs, Linda Zhang, Senior Portfolio Manager and Head of Research at Windhaven Investment Management, pointed out some limitations in market cap-weighted equity indices that may expose investors to unwanted risks.
For instance, as a market-cap weighted index, the Nasdaq-100 is top heavy, with a large tilt toward the the largest companies. Apple (NasdaqGS: AAPL) weight in the index is the equivalent to the bottom 50 names, Zhang said. A play on the Nasdaq-100 is essentially a large bet on Apple stock.
The market cap-weighted indices may also expose investors to other fundamental risks as the weighting methodology would attach more weight toward indebted countries or companies, Zhang added. For example, looking at the Bloomberg Eurozone Sovereign Debt Index, four of the top five country tilts are those with above average public debt relative to the size of their respective economies – a market cap-weighted bond index would have larger positions in countries that have issued more bond securities, or those with more debt.
On the other hand, investors may turn to factor-based or smart-beta ETFs to capture alternative indexing methodologies.
“Multi-factor strategy may provide more consistent return premium due to factor diversification,” Zhang said.