As the markets push higher, many investors have turned to cheap and easy-to-use ETFs, but blindly funneling money into the most prominent ETF options available may come with some risks, especially in an extended bull market environment.
Martin Flanagen, president and chief executive of Invesco, warned that relying on market cap-weighted methodologies could inflate losses if the equities market take a nosedive, the Financial Times reports.
Most of the largest U.S.-listed ETFs on the market are benchmarked to traditional market capitalization-weighted indices. These cap-weighted indices, like the appellation suggests, weight company stocks by the overall market capitalization. Consequently, the largest companies, which have grown the most or exhibit higher valuations during a bull market rally, make up the largest weights within these indices.
“Too many people have created their total portfolios with cap-weighted indexes thinking they are safe and cheap,” Flanagan told FT. “The reality is they are turning more and more into momentum plays. You are ending up with a disproportionate amount of your portfolio in the biggest stocks.”
For example, the S&P 500, a widely observed benchmark for large U.S. companies, is currently overweight five large technology companies, including Apple (NasdaqGS: AAPL), Alphabet’s (NasdaqGS: GOOGL), Microsoft (NasdaqGS: MSFT), Amazon (NasdaqGS: AMZN) and Facebook (NasdaqGS: FB), which make up close to 12% of the index.
Flanagan cautioned that investors may be unaware of the high concentrations in funds that track market cap-weighted indices if they thought the investments would provide broad and diversified exposure, especially as the 10 largest stock ETFs in the U.S., which are weighted by market cap, have attracted close to $65 billion in net inflows year-to-date.
“I am concerned about the financial impact to people who might not understand their exposures,” Flanagan told FT.
Related: How to Determine if Smart Beta ETFs Fit in Your Portfolio
Nevertheless, these market cap-weighted ETFs still help investors access broader swathes of the market through a single investment vehicle.
“The claims about concentration are really unfounded,” Matthew Bartolini of State Street’s ETF unit, told FT. “You are definitely going to have a skew to the larger cap companies but you still have another 400 odd stocks that you have exposure to as well.”
Alternatively, investors may also look to smart beta or alternatively index-based ETFs that may equally weight holdings or weight components based on fundamental screens, like sales or profits, as a better way to diversify, such as those offered by Invesco PowerShares and others.
For more information on ETFs, visit our ETF 101 category.