Investing in market-cap weighted ETFs has several advantages, but also carries certain risks. We take a look at how strategic beta strategies are redefining index investing to provide new opportunities for ETF investors.

Beyond market cap weighting

Index tracking ETFs provide quick, scalable and cheap market exposure to a wide range of markets and asset classes. These attributes are the key to their huge popularity with investors over the last decade. However, not all index strategies are created equal. It’s therefore important for investors to understand the different roles that index funds can play in diversified portfolios.

The most common approach is to track a market-cap weighted index. Market-cap weighted ETFs simply track an index that is based on the size of its constituents. These indices are generally cheap to track, so market-cap weighted ETFs can help investors gain low cost access to a broad range of global markets.

However, because equity indices give the biggest weightings to the biggest companies, equity market-cap weighted ETFs are focused on those securities and markets that have performed well in the past, not necessarily those that will perform well in the future. Bond indices, on the other hand, give bigger weightings to the biggest debt issuers (in other words the biggest borrowers) so they are biased to the most indebted issuers, not necessarily the most solvent. As a result, market-cap weighted ETFs can expose investors to several unrewarded risks.

Risk-aware indexation using a smart beta approach

The risk biases inherent in market-cap weighted ETFs can be particularly detrimental when applied to less liquid or less diversified markets. Take emerging market debt, for example. This is a popular asset class, much in demand for the attractive yield it offers in today’s low interest rate environment. However, because traditional emerging market debt indices have their biggest weightings in the most indebted issuers, they can expose investors to significant country-specific risks.

Traditional emerging market debt indices also contain many smaller, less liquid bonds that do not necessarily impact returns but can significantly impact transaction costs. And because they are driven entirely by debt issuance, traditional indices take no account of the changes that can occur to credit ratings or duration exposures over time, regardless of the end investor’s objectives.

Fortunately, there are alternative, more risk-aware options for ETF investors looking to gain cost-effective exposure to riskier and less liquid markets and asset classes. In recent years, index providers have started to build “smart beta” indices that use criteria other than the size of a company or issuer to determine portfolio holdings.

Many of these smart beta ETFs track indices that weigh constituents equally, or that screen for securities with specific characteristics—such as low valuations, strong earnings or price momentum, or credit quality. And some do both. In all cases, the aim is to minimise the unrewarded risks that are inherent in market-cap weighted ETFs.

Towards a “smarter” index

A good example of how smart beta ETFs can provide exposure to riskier markets is provided by our JPM USD Emerging Markets Sovereign Bond UCITS ETF (JPMB). This smart beta ETF tracks the JPM Emerging Market Risk Aware Bond Index—an innovative benchmark that applies a liquidity screen to remove smaller and less liquid bonds, a risk screen to remove the 10% of the index by market cap that is at highest risk of default, and a credit stabilisation filter to ensure that 75% of the risk of the index is always driven by high yield securities.

These filters help reduce sovereign default risk (Venezuela, for example, has been excluded since 2010), maintain high levels of liquidity, and deliver a competitive yield compared to debt-weighted indices and other approaches that focus only on liquidity, or only on quality screening. JPMB is therefore able to provide lower volatility exposure to emerging market debt with the potential for more consistent returns.

Index funds are not created equal  

With the advent of smart beta ETFs, investors are no longer confined to market-cap weighted indices. As the example of JPMB shows, in less liquid and less efficient markets, it’s important to choose the most appropriate index approach. Otherwise, investors can potentially be exposed to significant unintended portfolio biases and greater unrewarded risk concentrations than they perhaps bargained for.