“A market-cap-weighted fund by its very design increases investment in an appreciating stock and decreases investment in a falling stock. The bigger a company gets, the more it costs to buy that stock. But of course the converse is also true. So as more and more money flows into cap-weighted products, the top stocks may get overbought or oversold. That’s just inherent to the methodology,” according to VictoryShares.

Alternatively, investors may considered a risk-weighted approach to better diversify their market exposure. Victory Capital offers its own suite of smart beta ETFs that focus on volatility-based weighting methodology to potentially help investors generate improved risk-adjusted returns. For example, the VictoryShares US 500 Enhanced Volatility Wtd ETF (CFO), VictoryShares US EQ Income Enhanced Volatility Wtd ETF (CDC) and VictoryShares US 500 Volatility Wtd ETF (CFA) start with the broad market and screens for companies with four quarters of positive earnings. Those stocks are then weighted based on their standard deviation over the past 180 trading days. Stocks with lower volatility are given higher weightings and stocks with greater volatility are given lower weightings. Ultimately, all securities that pass the earnings criteria are present, just at different weights.

“We prefer an indexing methodology based on risk,” Dhillon added. “A volatility-weighted index de-emphasizes concentration risk and seeks to equalize the risk contribution among all constituents. I maintain that volatility-weighted indexes have the potential to perform more consistently in a variety of environments, which is particularly important where we are in the cycle today.”

For more on smart beta ETFs, visit our Smart Beta Channel.