Many investors are not aware of the unintended risks that cap-weighted ETFs can introduce into portfolios.
Particularly in the U.S. large-cap space, many investors look to top-heavy, growth-tilted indexes such as the S&P 500. Investors looking to take smarter risks can use alternative approaches, such as multifactor strategies, to get a more balanced exposure.
Multifactor ETFs seek to target desired return-enhancing factors and reduce exposure to unrewarded risk exposures, enabling investors to take smarter risks.
While investing in the broader market – a collection of companies based on size — seems like it should offer balanced exposure, it may actually introduce unintended risks.
Risks in Cap-Weighted ETFs
First, cap-weighted funds are inherently backward-looking. Cap-weighted funds continue to allocate more assets to past performers, regardless of where valuations stand. Meaning, they’re potentially allocating a significant portion of a fund to overbought or overvalued stocks.
Additionally, cap-weighted funds – particularly in the U.S. large-cap space – have reached record levels of concentration in recent history. But concentration risk is prevalent at both the company and sector levels.
Being overly concentrated at the company level introduces significant idiosyncratic company risk. There is an overrepresentation of mega-caps, while persistently under-representing large caps deeper within the universe.
At the sector level, bubble events can enhance exposure at inopportune times. In the current environment, the information technology sector comprises nearly half of cap-weighted S&P 500 funds by weight.
Volatility risk is also a concern when allocating to cap-weighted funds. Investing in funds that are not mindful of volatility when selecting securities introduces behavioral and capital growth challenges.
The Hartford Multifactor US Equity ETF (ROUS ) is a multifactor U.S. equity ETF that seeks to outperform traditional cap-weighted indexes while offering less volatility. ROUS seeks to reduce volatility by 15% over a full market cycle.
For more news, information, and analysis, visit the Multifactor Channel.
Investing involves risk, including the possible loss of principal.
This article was prepared as part of Hartford Funds paid sponsorship with VettaFi. Hartford Funds is not affiliated with VettaFi and was not involved in drafting this article. The opinions and forecasts expressed are solely those of VettaFi. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, a recommendation for any product or as investment advice.
