Why It’s Important to Mitigate Concentration Risk

Many investors may be surprised to see how concentrated their exposure to the broader market really is.

While investing in the broader U.S. market – a collection of companies based on size — seems like it should offer balanced exposure, it may actually introduce significant concentration risk to portfolios.

Many investors look to top-heavy, growth-tilted indexes such as the S&P 500 for exposure to the U.S. large-cap space. However, with cap-weighted indexes recently reaching record levels of concentration, it may be worthwhile to consider an alternative approach.

A multifactor ETF can offer more balanced exposure and help investors take smarter risk. Compared to the benchmark, a multifactor ETF aims to target desired return-enhancing factors and reduce exposure to unrewarded risk exposures.

The Hartford Multifactor US Equity ETF (ROUS) may be a solution for investors looking for more balanced exposure to the broader market. The fund is designed to provide equity exposure with potentially less volatility and risk than traditional cap-weighted indexes.

Concentration and Other Risks in Cap-Weighted ETFs

As mentioned, cap-weighted funds have reached record levels of concentration in recent history, but it’s important to note that concentration risk is prevalent at both the company and sector levels.

Being overly concentrated at the company level introduces significant idiosyncratic company risk. There is an overrepresentation of megacaps, while persistently under-representing large-caps deeper within the universe.

At the sector level, bubble events can enhance exposure at inopportune times. In the current environment, the information technology sector comprises nearly half of cap-weighted S&P 500 funds by weight.

Additionally, cap-weighted funds are designed to continue to allocate more assets to the past top performers, regardless of where valuations stand. Meaning, they’re potentially allocating a significant portion of a fund to overbought or overvalued stocks.

Finally, volatility risk is also a concern worthy of consideration when allocating to cap-weighted funds. Investing in funds that are not mindful of volatility when selecting securities introduces behavioral and capital growth challenges.

For more news, information, and analysis, visit the Multifactor Channel.

Investing involves risk, including the possible loss of principal.

This article was prepared as part of Hartford Funds paid sponsorship with VettaFi. Hartford Funds is not affiliated with VettaFi and was not involved in drafting this article. The opinions and forecasts expressed are solely those of VettaFi. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, a recommendation for any product or as investment advice.