For example, over the past decade, MSCI has introduced factor-based indices that screen for value, small capitalization, momentum and minimum volatility to potentially enhance returns and reduce drawdowns during sell-offs. The strategic beta solution would neutralize some risks, better diversify a portfolio and potentially generate improved risk-adjusted returns.
“A multi-factor approach created a more diversified solution with a more consistent return structure,” Chris Shuba, Founder of Helios Quantitative Research, said. “The result is a more comprehensive and durable product for our risk managed models.”
By screening for these factors and others, investors may limit overconcetration of risks. For instance, Dahya pointed out that global developed equities from the FTSE Developed Index during the pre-financial crisis in January 2007 had a 28% tilt toward financials, which took on 44% of the risk in the financial downturn sell-off. A market cap-weighted index may also included overvalued securities, such as Yahoo (NasdaqGS: YHOO) and Cisco (NasdaqGS: CSCO) in the Nasdaq-100 during the peak of the tech bubble.
To better diversify away from overweighting toward potentially overvalued areas of the market, J.P. Morgan has developed a line of smart-beta or multi-factor ETF strategies, including the JPMorgan Diversified Return International Equity ETF (NYSEArca: JPIN), which screens for value, momentum, size and low volatility. The resulting portfolio includes a more evenly distributed sector and individual component weights.
“Traditional indices allow market cap to dictate allocations, leading to risk concentrations,” Dahya said. “Market cap is not predictive of future returns. We believe equal distribution of risk across regions and sectors is a more prudent allocation approach.”
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