Market-cap-weighted strategies have dominated the investment landscape when it comes to exchange-traded funds (ETFs). Is it the low cost and simplicity of these funds that are appealing, or do investors dangerously believe that market-cap-weighted funds are lower risk than other mutual funds and ETFs?
In the first and second quarters of 2018, Invesco commissioned a survey to take the pulse of investors and financial advisors. The research focused on low-cost ETFs that are designed to closely track a broad equity market index, such as the S&P 500. The research revealed a disconnect between market expectations and portfolio allocations in market-cap-weighted strategies.
What is market cap weighting?
A stock’s market capitalization is calculated by multiplying its share price by the number of outstanding shares. So, a company with 1 million shares and a stock price of $10 would have a market cap of $10 million. When an ETF is weighted by market cap, it means that the companies with the largest market caps have the largest allocations. These funds are sometimes called “bulk beta” ETFs.
In contrast, other types of ETFs take different approaches. For example, some will give equal weighting to each stock in an index. Others select and weight stocks based on investment factors such as low volatility, high quality or dividend yield.
The concept is fairly simple, but there are important ramifications to each approach. For example, during the tech bubble, when certain companies experienced soaring stock prices, they also experienced soaring market caps. This means that investors in bulk beta ETFs would have had increased exposure to these companies — which was a definite risk when the tech bubble burst.
Despite tempered market outlook, market-cap-weighted ETFs remain popular among advisors
Our previous research report showed that a majority of investors and advisors reported their expectation of two to three more market adjustments this year, along with a market decline of about 20% by the end of the year. Moreover, investors and advisors both reported that they see a recession on the horizon by 2021. Yet, despite this tempered outlook, advisors continue to recommend that up to 44% of a client’s portfolio should be allocated to bulk beta ETFs. This is unsettling because bulk beta ETFs are directly exposed to the volatility and market downturns that investors are concerned about and expect in the near future.
Most investors don’t understand market-cap-weighted ETFs
Advisors overestimate their clients’ understanding of bulk beta ETFs, claiming that 57% of their clients generally understand the product. But in fact, a striking 74% of advised investors reported they are not familiar with bulk beta ETFs, even when presented with detailed explanations of these funds.
In addition, most investors also reported that their advisors have not discussed bulk beta ETFs as a possible investment strategy or cannot recall such a discussion. More than 60% of investors were unsure how much of their portfolio is dedicated to bulk beta ETFs — and among those who knew, 24% seems to be the average percentage of an investor’s portfolio allocated to bulk beta ETFs.
Reliance on market-cap-weighted ETFs for risk aversion is dangerous
Among investors familiar with bulk beta ETFs, most investors (70%) said they are lower risk than ETFs and mutual funds. In contrast, most advisors (72%) view bulk beta ETFs to be just as risky as other funds.
While most advisors understand the risks associated with market-cap-weighted strategies, over one-quarter present bulk beta ETFs as a low-risk way to match the market’s performance. Our survey also shows that during client conversations, advisors who think there will be a major market disruption in 2018 are more likely to present bulk beta ETFs as low risk, while those who do not think a disruption will occur are more likely to present them as low cost.
More advisors who present bulk beta ETFs as low risk agree that they struggle with risk aversion, client expectations and convincing their clients to stay in the market during periods of high growth as compared to those who emphasize the low cost. To avoid misconceptions, advisors may be better served by highlighting the low cost of bulk beta ETFs rather than presenting them as low risk.
Being over-indexed means missing out
Nearly half of advisors (48%) believe there is no such thing as being over-indexed, and 36% are recommending that investors increase their allocation to bulk beta ETFs. Furthermore, 66% believe a client can have a balanced portfolio that consists “entirely” of bulk beta ETFs. However, constructing portfolios entirely of bulk beta strategies could mean missing out on some of the targeted strategies in factor-based funds, as well as other active funds that are designed to mitigate the effects of volatility or market downturns.
The current market environment and continuing interest in passive investing points to a need for a comprehensive portfolio construction conversation focused on client outcomes and the role and risks of bulk beta ETFs. At Invesco, we believe an opportunity to achieve various unique investment objectives is through high-conviction portfolios that go beyond the limitations of traditional market benchmarks. High-conviction portfolios can include actively managed funds, factor strategies and traditional passive approaches that are all intentionally chosen and allocated with a client’s goals in mind.
Learn more about how smart beta factors and methodologies outperformed the S&P 500 and MSCI EAFE indexes over multiple market cycles and different economic climates.
Read associated research — Growing sentiment gap: Market outlooks differ among financial advisors and investors
Blog header image: Invesco
Source: All data from Invesco’s research. Invesco hired market research firm GfK to conduct surveys to better understand the pulse of financial advisors and investors. The first round of research (initial pulse) was conducted in January. The second round (re-pulse) was conducted in April to gauge the investment climate after February’s market adjustment causing volatility to spike.
Methodology (initial pulse):
GfK conducted an online survey of 1,015 investors who use a financial advisor and have at least $100K in investible income using KnowledgePane™ and 811 financial advisors using an opt-in sample. The investor survey was conducted from January 18-23, 2018, while the financial advisors survey was fielded from January 18-27, 2018. Importantly, these surveys were fielded before the market changes that began on February 5. The margin of error for the KnowledgePanel investor sample is +/-3.4 percentage points.
GfK conducted an online survey of 500 investors who use a financial advisor and have at least $100K in investible income using KnowledgePanel™ and 403 financial advisors using an opt-in sample. The investor survey was conducted from April 10-17, 2018, while the financial advisors survey was fielded from April 10-26, 2018. The margin of error for the KnowledgePanel investor sample is +/- 4.8 percentage points. Totals may appear as though they do not to sum to 100% due to rounding and respondents who refused their participation.
GfK maintains a proprietary panel called KnowledgePanel®, which is the largest online probability-based research panel in the US. The respondents were paid an honorarium for their participation in the research. Investors received about $1.50 per survey. Advisors received $2 in e-currency. E-currency is money that you can use on items the panel offers – typically gift cards.
Invesco is not affiliated with GfK.
An investment in exchange-traded funds (ETFs) may trade at a discount to net asset value, fail to develop an active trading market, halt trading on the listing exchange, fail to track the referenced index, or hold troubled securities. ETFs may involve duplication of management fees and certain other expenses. Certain of the ETFs the fund invests in are leveraged, which can magnify any losses on those investments.
Many products and services offered in technology-related industries are subject to rapid obsolescence, which may lower the value of the issuers.