Escape the mega cap ETF trap: The benefit of redistributing risk
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
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.