Smart beta exchange traded funds that pick companies based on various proven market factors have grown as a popular alternative to diminish risks associated with traditional market capitalization-weighted index funds.

In the Top Smart Beta Strategies for 2017 panel on the annual online ETF Trends Virtual Summit (available on-demand for up to 4 CE Credits), Arne Noack, Director of ETP Manufacturing at DeAM, Todd Mathias, Vice President of Franklin Templeton Investments, and Mannik Dhillon, Head of Investment Solutions, Product and Strategy at Victory Capital, weighed in on the risks of traditional market capitalization-weighted indexing methodologies and looked to strategic- or smart-beta strategies as a viable alternative that helps diversify and diminish risks.

The strategists pointed to four major unintended risks driven by the market price and shares outstanding of the underlying stocks in a cap-weighted index fund, including overweight mega-cap stocks, exposure to over-valued stocks, heavy sector weights and high geographic weighs in global indices.

Cap-weighted indices focus on large- and mega-cap stocks, with the largest 2% of companies in the MSCI ACWI Index accounting for 26% of the benchmark. Based on the price-to-earnings ration compared to the 10-year average P/E, 72% of the top ten components in the MSCI ACWI are overvalued.

Due to their weighting methodologies, traditional indices are also heavy on specific sectors – the S&P 500 has seen its tech component rise to 33% from 12% from 1997 through 1999, which has dragged down performance when the technology bubble burst in 2000.

Additionally, looking at global indies,  the largest economies also make up large weights in international index funds. For instance, the three largest continues in the MSCI Emerging Markets Index account for 53% of the benchmark.

Alternatively, more are turning to smart beta ETF strategies following customized indices that screen for specific factors.

“Most define smart beta ETFs as those that rely on some type of underlying strategy or factors while others simply indicate they are anything but a market cap-weighted ETF,” Dhillon said.

“Protecting portfolio assets is top of mind for advisors, and several findings suggest that advisors may view smart beta similarly to active management,” Noack said. “Advisors have an interest in using smart beta to protect portfolios in down markets, control volatility and increase alpha.”

Mathias pointed to four factors that have played at big roll over the years, including high quality, attractive value, strong momentum and low volatility. Quality refers to companies that exhibit profitability, strength of balance sheets and efficient use of assets. Value includes companies with attractive valuation ratios.and dividend yields. Momentum covers those that exhibit 6- to 12-month relative price strength. Lastly, low volatility companies are those that demonstrate lower than average variability of returns.

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