Market-cap-weighted ETFs: Not always what they’re cracked up to be

Significant assets continue to flow into passively managed mutual funds and exchange-traded funds — a trend that shows no signs of slowing. Investors who want to “buy the market” have poured large sums into ETFs largely due to their low cost, transparency and tax efficiency potential.
Yet there is an underlying issue with these products investors may not recognize: They think all broad-based core ETFs give a diversified representation of the market. Instead, they are often riding the fortunes of a handful of stocks.
If you buy ETFs for exposure to major indexes such as the Russell 1000, which provides exposure to large and mid-cap securities covering the largest 1,000 in the market, isn’t that diversified? Yes and no. Certainly the inclusion of mid-cap securities makes this more diversified than the S&P 500.
So what’s the problem?
Three words: market cap weighting. It can help deliver gains when times are good but can damage the diversification investors often blindly rely on when allocating to many index-based ETFs.
CONCENTRATION RISK
The collective enthusiasm of investors can drive higher allocations to the largest securities in an index, creating concentration risk. When overly optimistic investors pushed Japanese equity prices higher than the rest of the world in the 1980s, the weight of Japan in the global market place (as represented by the MSCI World Index) increased from 10% in 1985 to 35% by 1989. Then began a decade-long correction where investors in market-cap-weighted indexes paid heavily for over-exposure.
(More: Making bigger bets with smaller portfolios)
Strong gains in recent years have imbued market-cap-weighted indexes, such as the S&P 500 and Nasdaq 100, with increasing levels of sector biases, particularly to energy, financials and technology. The rise in the stock prices of companies such as Facebook, Amazon, Netflix, Google and Apple give technology an outsized influence over both popular indexes. This ties the fortunes of average investors to the prospects of the next iPhone launch far more than they may realize.
Over time, indexes become increasingly overweighted toward what has already done well. This means investors may have less exposure to what may be about to do well. It also amplifies the impact of individual stocks on the major cap-weighted indexes, which may add to overall volatility in the short term.
The result is indexed ETFs that are increasingly exposed to the performance of a smaller and smaller number of stocks.
Consider the Aug. 17-21 market correction: A mere 13 stocks were responsible for over 25% of the S&P 500’s fall. Just six stocks — Apple (5.5%), Microsoft (3%), ExxonMobil (2.45%), Chevron (1.8%), Facebook (1.65%) and Bank of America (1.6%) — together accounted for roughly 16% of the week’s decline.
It was even worse for the Nasdaq Composite Index. Three stocks — Apple, Microsoft and Facebook — pushed it down more than 20% for the week.
That’s not what anyone thinks of as “broad market exposure.” Yet this is what investors who held market-cap-weighted ETFs experienced. One day they were flying high with the market, then on a Monday morning (Aug. 25) many were grounded.
That’s why we advocate against an overconcentration to market-cap-weighted ETFs: too many eggs in too few baskets. There are many products to consider including new, alternatively weighted strategies in ETF format that can better help investors achieve their objectives.
EASY CASE FOR DIVERSIFICATION
This makes an easy case for diversification. When market indexes are flying and everyone’s making seemingly easy money, no one wants to think about diversification or balance in their portfolios. Then those annoying dips come, usually without warning. Priorities suddenly and inevitably change.
(More: Risk parity: The real culprit behind the market’s madness)
As an adviser, your best bet is to plan ahead, invest broadly and with conviction. Keep your eye on diversification, coach clients through volatile markets and ensure that they don’t panic or make irrational decisions.
While there is no guarantee, a true diversified portfolio can help investors capture nice pieces of upside without inflicting too much pain on the downside. Think of it as saving for a better house without betting the current one.
Of course that leads to the proverbial question, “What should investors do instead?”
Before the recent uptick in volatility, investors and financial media bought wholly into the concept that passively managed market-cap-weighted ETFs were easy winners. The bloom has come off that rose a bit, but that does not mean passive has become toxic — far from it.
However, ETF investors should understand their true exposures and better diversify across risks.
Many compelling ETF products are being offered that can help investors achieve their objectives, whether capital preservation, income, growth, or combinations of the three. Some combine passive elements with more active management, offering quality and diversification.
Rick Genoni is head of the ETF business at Legg Mason.