Index ETFs have been a popular play this year, with the ETF industry attracting another year of record inflows, but as investors jump on the ongoing bull market rally, traditional market cap-weighted index funds may pose risks that many may have overlooked.
U.S-listed ETFs have attracted a record $473.9 billion in net inflows this year, according to XTF data. S&P 500 Index-related ETF are among 2017’s most popular ETF plays. Year-to-date, the SPDR S&P 500 ETF (NYSEARCA: SPY) saw $12.1 billion in net inflows, iShares Core S&P 500 ETF (NYSEARCA: IVV) attracted $30.2 billion in new inflows and Vanguard 500 Index (NYSEARCA: VOO) added $14.6 billion.
The inflows come in as U.S. equities extend their bull market run to their ninth year, with technology stocks like Apple (NasdaqGS: AAPL) and Facebook (NasdaqGS: FB), among others, leading the charge in a growth-fueled market rally. Year-to-date, the S&P 500 increased 21.9% while the S&P 500 Information Technology Index jumped 37.6%.
However, this ongoing surge in U.S. technology stocks may leave traditional market cap-weighted index funds, like the S&P 500-related ETFs, exposed to risks due to their increasingly larger tilt toward the information technology segment. According to the Wall Street Journal, tech stocks made up 19.7% in the widely followed S&P 500 benchmark, and over the past 10 years, the weighting of the tech sector in the S&P 500 at year-end averaged 19.6%. However, information technology companies now make up around 24% of the S&P 500-related ETFs.
“It’s sort of an inherent flaw of index funds,” Kyle Moore, founder of Quarry Hill Advisors, told the WSJ, referring to how outperforming stocks tend to have a bigger share of indices that are market-capitalization weighted, such as the S&P 500.
Alternatively, ETF investors can diminish risks posed by traditional market cap-weighted indexing methodologies by looking at alternative index-based ETF strategies.
For instance, the obvious alternative to solve potential risks posed by overweighting due to the rising market cap of the technology segment is through an equal weight index-based strategy, such as the Guggenheim S&P 500 Equal Weight ETF (NYSEArca: RSP), which tracks the S&P 500 Equal Weight Index.
The underlying S&P 500 Equal Weight Index is the equal weight version of the S&P 500 Index. The equal-weight index contains the same component holdings as the cap-weighted S&P 500, but each company in the S&P 500 Equal Weight Index is allocated the same weight at each quarterly rebalance. Consequently, the holdings are balanced across all of the S&P 500 companies evenly over time. In contrast, the market cap-weighted S&P 500 Index overweights the 50 largest companies with close to 50% of the holdings.
Because of its indexing methodology, RSP only holds a 13.3% tilt toward the technology segment and holds an overweight 16.1% position in consumer discretionary. Furthermore, due to its equal weight focus, it will lean toward smaller names, with mid-caps making up 48.3% of the fund’s portfolio, followed by 39.5% large-caps and 11.0% mega-caps.