Plain vanilla, market-cap weighted or beta-index ETFs have been a mainstay in investor’s portfolios, but these traditional investments come with risks, especially in a prolonged rally. Alternatively, investors can look to smart beta or alternative index-based strategies to address the potential issues.
“For years investors have flocked to ETFs that track market-cap-weighted indexes,” Mannik Dhillon, president of VictoryShares and Solutions, said in a new whitepaper Cap-weighting: A wolf in sheep’s clothing. “But this herd mentality may be dangerous, particularly with regard to the perceived diversification benefits. I think it’s time we acknowledge that there may be severe limitations to cap-weighting.”
When the going is good, passive market-cap weighted methodologies can help investors ride the markets higher and diversify across a broad market. This also creates an unforeseen risk since the largest components or largest companies by market capitalization are also those that have performed the best. Consequently, investors who are now overweight these big companies in a market cap-weighted fund are exposed to the downside risks when these high-flying stocks suddenly take a turn.
“Contrary to popular belief, cap-weighting is not an all-weather strategy,” Dhillon asserts. “I think there are better index construction methodologies that can deliver the benefits that passive investors crave, especially considering where we are in the cycle.”
For example, Facebook’s second quarter 2018 earnings report triggered a share price decline of more than 20%, or a market cap loss of more than $120 billion, in a single day. Prior to the report, Facebook shares made up 2% of the S&P 500, which resulted in a significant performance drag on S&P 500 ETFs.