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Market cap-weighted ETFs have dominated the investment landscape over the last 20 years. But in today’s unpredictable market environment, investors are increasingly turning away from traditional passively-managed ETFs and toward a more diversified approach in the quest for better beta.
With the global economy warming up, but political uncertainty going nowhere fast, it’s more important than ever for investors to position their global portfolios to navigate long-term market volatility. In the search for diversification and cheaper access to pure market beta, many investors turn to passive index ETFs, which track a market cap-weighted index.
A market cap-weighted index is a stock market index whose individual components are weighted according to the total market value of the shares. As share prices go up, securities may become overvalued and their market capitalization—the price multiplied by the number of shares outstanding—increases. A market cap-weighted index simply increases weights to securities as prices rise, without regard for valuations.
Funds that track a market cap-weighted index aren’t always the most effective way to steer a steady course through volatile markets, and there is one major reason why—a lack of diversification. Traditional market cap-weighted indices are actually less diversified than investors may think. As a result, they come with some inherent weaknesses, including exposure to unrewarded risk concentrations and overvalued securities.
For example, in March 2016, nearly 50% of risk in the S&P 500 was attributed to the top 10% of stocks.
Market cap-weighted index: Risk concentration at market top
Company-specific risk concentration by decile in S&P 500 Index, March 2016
The result is that these indices may spike in rising markets over the short term, but investors can also experience painful downturns, which increase volatility and reduce long-term performance.
An attempt to break the link between index weights and market capitalization—and therefore avoid this concentration in sectors that have outperformed—has led to the next innovation in index investing: strategic, or smart, beta. Whereas traditional passively-managed indices allow market cap to dictate allocations, strategic beta indices seek to minimize exposure to regions and sectors that have historically represented a higher risk, therefore diversifying the risk concentrations inherent in market-cap ETFs.
Learn more about J.P. Morgan’s strategic beta equity ETFs here .
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