ETF investors seeking to enhance their portfolio mix can consider a smart beta strategy based on a TOBAM methodology that challenges conventional diversification wisdom.
In the recent webcast, 99 Problems, but Concentration Isn’t One: A New Approach to Diversification, Mark Hackett, Chief of Investment Research, Nationwide, outlined the current market environment we are in after a tough coronavirus induced pullback and subsequent rally in equities. Looking ahead, Hackett highlighted the importance of earnings to the continued rally.
Meanwhile, supportive factors may help maintain the upward momentum and fuel growth ahead. For example, government policy remains accommodative on both the fiscal and monetary sides.
Investors, though, have become anxious in light of rising rates as yields on benchmark 10-year Treasury notes quickly jumped to one year highs over a one month period. Nevertheless, stocks haven’t been troubled by big interest rate jumps in the past. Looking at historical data since 2003, the S&P 500 has still returned an average 18% over a one-year period after large moves in the 10-year Treasury yield.
Hackett also underscored a number of factors that may continue to maintain market growth ahead, including tailwinds like fiscal stimulus, monetary stimulus, improving economic conditions, improving earnings growth, political clarity, coronavirus case reductions, vaccine rollouts, and improving equity flows.
Dr. Tatjana Puhan, Managing Director, Deputy Chief Investment Officer, TOBAM, argued that investors should separate the myths from the facts when navigating the markets, especially in addressing long-term diversification. For starters, she believes that passive investments do not necessarily translate to neutral investments since using a biased market cap-weighted benchmark as a reference may carry heavy and potentially costly implicit bets, which tend to evolve dynamically over time. For example, the information technology component of the S&P 500 made up 34% of the benchmark index at the height of the dot-com bubble while financials made up 34% of the benchmark during the global financial crisis. Puhan warned that market cap-weighted benchmarks are hugely biased.
“Market cap-weighted indexes tend to attribute greater representation to stocks or factors as they appreciate and less representation as their prices decline – the greater the imbalance, the greater the impact of price changes,” Puhan said. “The better a stock or factor has performed in the past, the greater the propensity to overweight these past winners which necessitates greater outperformance of these positions – betting on past winners is speculation, not diversification.”
Puhan advised investors to look more closely at correlation of holdings rather than just focusing directly on specific holdings. All the independent risk factors present in the market are represented in the portfolio, even if the portfolio has no position in a given stock or sector.
Puhan also pointed out that investors should reconsider risks in tracking errors. Tracking error measures the distance between two portfolios. It is a relative measure, not an absolute measure of risk, hence it depends on the basis of comparisons. Tracking errors do not measure economic capital risk, drawdown risk, and concentration risks.
“Comparing a portfolio to a market cap-weighted index may consequently make a portfolio that does not have the same extreme bets as the market cap-weighted portfolio appear ‘risky’ even if the opposite is true,” Puhan said. “There are plenty of studies that show that by focusing on tracking error as a risk measure, portfolio managers have little incentive to build portfolios that really are ‘better’ than the extremely biased cap-weighted portfolio.”
Financial advisors who are interested in learning more about smart beta strategies can watch the webcast on demand.
Both actively and passively managed funds involves risk and principal loss is possible. active investing has higher management fees because of the manager’s increased level of involvement while passive investing has lower management and operating fees. Actively managed funds may have higher portfolio turnover than passively managed funds. Excessive turnover can limit returns and can incur capital gains.
S&P 500 – Standard & Poor’s 500 Index, is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
Smart Beta – A smart Beta ETF is a type of exchange-traded fund (ETF) that uses a rules-based system for selecting investments to be included in the fund portfolio. An exchange-traded fund or ETF is a type of fund that tracks an index such as the S&P 500. Smart beta ETFs build on traditional ETFs and tailor the components of the fund’s holdings based on predetermined financial metrics.
This article was prepared as part of Nationwide’s paid sponsorship of ETF Trends.
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