Plain vanilla, market-cap weighted or beta-index ETFs have been a mainstay in investor’s portfolios, but these traditional investments come with risks, especially in a prolonged rally. Alternatively, investors can look to smart beta or alternative index-based strategies to address the potential issues.
“For years investors have flocked to ETFs that track market-cap-weighted indexes,” Mannik Dhillon, president of VictoryShares and Solutions, said in a new whitepaper Cap-weighting: A wolf in sheep’s clothing. “But this herd mentality may be dangerous, particularly with regard to the perceived diversification benefits. I think it’s time we acknowledge that there may be severe limitations to cap-weighting.”
When the going is good, passive market-cap weighted methodologies can help investors ride the markets higher and diversify across a broad market. This also creates an unforeseen risk since the largest components or largest companies by market capitalization are also those that have performed the best. Consequently, investors who are now overweight these big companies in a market cap-weighted fund are exposed to the downside risks when these high-flying stocks suddenly take a turn.
“Contrary to popular belief, cap-weighting is not an all-weather strategy,” Dhillon asserts. “I think there are better index construction methodologies that can deliver the benefits that passive investors crave, especially considering where we are in the cycle.”
For example, Facebook’s second quarter 2018 earnings report triggered a share price decline of more than 20%, or a market cap loss of more than $120 billion, in a single day. Prior to the report, Facebook shares made up 2% of the S&P 500, which resulted in a significant performance drag on S&P 500 ETFs.
“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.”
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