Traditional market capitalization-weighted indexing methodologies pose hidden risks in a prolonged bull market environment. Alternatively, investors may look to smart beta or rules-based index exchange traded fund strategies that may limit these risks and potentially help enhance returns.
On the upcoming webcast, Moving Beyond Cap-Weighted Investing For Today’s Volatile Market, Mark Hackett, Chief of Investment Research at Nationwide, Shana Martin, ETF Product Manager at Nationwide, and Mark Burns, Smart Beta Product Specialist for Rothschild Risk Based Investments, will look at the hidden risks of traditional cap-weighting methodologies and consider strategic beta or alternative index-based strategies to diminish the risks while still maintain some upside potential.
For example, the Nationwide Risk-Based U.S. Equity ETF (NYSEArca: RBUS) can help provide “smart” diversification.
Smart beta ETFs “offer more deliberate allocations to potential sources of risk, avoiding the excessive exposures to unrewarded risks implicit in market cap-weighted indexing,” according to Nationwide.
In an extended bull run, market capitalization-weighted indexing methodologies may be more at risk since the largest components are often those that have increased the most during a bullish uptrend. Consequently, market-cap index fund investors may be exposed to the most pricey or overvalued segment of the market.
Related: Consider Smart Beta ETFs in an Extended Bull Market
In contrast, the Risk-Based U.S. Equity ETF will try to reflect the performance of the Risk-Based US Index, a rules-based, equal risk-weighted index designed to provide exposure to U.S. large-cap companies with lower volatility, reduced maximum drawdown and improved Sharpe ratio, compared to a traditional market cap-weighted index.
The top 500 equity securities by market-cap are taken and are then subjected to a marginal risk contribution calculation based on the security’s volatility and correlation to other securities for the past year. Securities are then ranked by marginal risk contribution, and 50% of those with the lowest marginal risk contribution are selected.
The equally-weighted risk contribution methodology incorporates each constituent’s volatility and correlation to the other constituents for the past year to create a portfolio where each holding contributes the same level of risk, which should produce lower overall volatility of the index, a higher risk-adjusted return and diminish maximum drawdowns.
Financial advisors who are interested in learning more about smart beta strategies can register for the Thursday, April 26 webcast here.