The investment industry is abuzz with talk of strategic—or smart—beta, as investors become increasingly aware of the overexposure to risk concentrations and overvalued securities that comes as part of the package with market cap-weighted ETFs. By redistributing risk weightings and filtering stocks based on a combination of different investment factors, investors can benefit from potentially smoother returns.
Traditional cap-weighted indices allow market capitalization to dictate their sector and regional allocations. This means they are most exposed to sectors and regions that have performed well in the past, not those that will necessarily perform well in the future. To overcome these unrewarded risk concentrations, alternatively-weighted indices can be constructed that aim to improve diversification across sectors and regions. At J.P. Morgan Asset Management, we have partnered with index provider FTSE/Russell to construct a proprietary risk-weighting process that re-distributes index weightings more equally and ensures risk is more evenly spread, therefore reducing exposure to historically volatile sectors and regions.
The benefits of such an approach are clear. At the moment, just three sectors—financials, consumer goods and industrials—account for two-thirds of the risk exposure in the FTSE Developed ex-NA Index, a well-known international equity index. In contrast, the FTSE Developed ex-NA Diversified Factor Index is explicitly designed to maintain greater balance across sectors. As a result, the factor index has a much smaller allocation to these three sectors, ranging from 8% to 12%
Impact of stock weighting method on sector allocations
Market cap-weighted index vs. alternatively-weighted index
Source: J.P. Morgan Asset Management, S&P 500. For illustrative purposes only.
Factor-weighted indices provide greater diversification, but they may underperform cap-weighted indices at certain times. If financials, for example, account for half of a cap-weighted index and bank stocks have a strong run over the short term, this index would, of course, be expected to outperform. However, such uncontrolled regional and sector risk concentrations may not be rewarded over the long term, and have more volatile returns.
One solution is to use indices that have greater diversification across sectors and regions. It is fairly uncontroversial to suggest that investors with exposure to a more broadly diversified index should achieve a smoother investment journey over time. It is therefore prudent to emphasize index diversification when constructing a core equity exposure with ETFs.
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Investing involves risk, including possible loss of principal. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investment returns and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be sold or redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.
Opinions and statements of market trends that are based on current market conditions constitute our judgment and are subject to change without notice. These views described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results. Investment returns and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. ETF shares are bought and sold throughout the day on an exchange at market price (not NAV) through a brokerage account, and are not individually redeemed from the fund. Shares may only be redeemed directly from a fund by Authorized Participants, in very large creation/redemption units. For all products, brokerage commissions will reduce returns.
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