Many investors are attracted to market-cap-weighted benchmark-index-based exchange-traded funds (ETFs), with the objective of obtaining stock market exposure at a low cost.1 As proof, investors have poured $70.8 billion into four broad-market-index-based ETFs over the past the year-and-a-half through June 2017.2 In their quest for low-cost equity exposure, however, investors may be overlooking some of the inherent features of market-cap investing that can lead to overweighting a sector when it falls out of favor. The bursting of the technology bubble in 2000, the financial crisis of 2008 and the oil crash of 2014–2015 provide prime examples.
Sector bets and the effects of market-cap investing
When choosing a strategy, investors should consider the fact that they are making sector bets and assuming sector risk. This is because market-cap-based indexes have differing sector exposures. Because market capitalization is a function of a stock’s price, investors in a passive broad-market index fund are allocating more of their investment toward stocks that have been rising in value, and less of their investment toward stocks that have fallen or are already out of favor. Consequently, when stocks revert to the mean, investors will be overexposed to falling stocks and underexposed to rising stocks. Whether conscious of it or not, these investors are chasing sector returns.
A history of valuation excesses
Historically, sector allocation within the S&P 500 Index has varied over time. Going back to 1990, the valuation excesses in technology, financials and energy provide telling examples of sector risk. Each of these sectors initially had strong fundamentals during their run-ups, but eventually fell on hard times — to the detriment of broad-market index investors.
Consider the recent history of the information technology and energy sectors. Strong corporate earnings and economic disruption have benefited technology companies, while energy stocks have been plagued by excess crude oil supply and the impact of fracking. By June 2017, technology’s weight within the S&P 500 Index reached levels last seen during the technology bubble, while energy’s weight within the index was flirting with lows last seen in 2003. These trends are evident in the chart below.
As we’ve seen in the past, sectors that have developed into a bubble have eventually deflated:
- The technology sector made up more than one-third of the S&P 500’s market cap in August 2000 before declining to 13.7% by September 2002.3
- The financials sector comprised 20.8% of the S&P 500’s market cap in September 2006 before declining by more than half to 8.9% by February 2009.3
- The energy sector made up 17.1% of the S&P 500’s market cap in June 2008, but hit a recent low of 5.9% in May 2017.3
The risks of being caught in sector troughs
What does this mean for investors? The table below displays the returns for the S&P 500 Index and the information technology, financials and energy sectors when their respective bubbles burst. The overweight to each sector when they deflated acted as a headwind to performance. During these periods, investors would have earned a higher return in each of the other sectors.
Recent sector allocations elevated in real estate, health care
So where do we stand now? The table below displays the historical sector weights for the S&P 500 Index from January 1990 through June 2017. As you can see, sector exposure is historically elevated in real estate, information technology, health care and consumer discretionary stocks, and underweight in energy, telecommunication services and consumer staples.
Sector downdrafts, coupled with the passive nature of index investing, are a reminder that funds that track the S&P 500 Index do not possess a strong rebalance and reconstitution process. The only changes come from the index committee’s decisions to make changes, which are typically the result of a major corporate event. The risk of getting caught in sector troughs is also a reminder that it would be attractive to have exposure to the sectors when they are out of favor and are ready to experience a recovery in fundamentals and weight within the index.
Fortunately, there is such an approach.
Smart beta strategies can help mitigate risk of sector exposure
Factor-based and smart beta methodologies have regularly scheduled rebalancing and reconstitution processes built into the methodologies, which can help to decrease the chances of chasing sector performance.
- For example, if a value stock runs up sharply and becomes expensive based on the methodology of a smart beta strategy, that stock would be systematically removed from the smart beta index — allowing investors to harvest gains and reinvest in a more attractive opportunity.
- Likewise, a momentum smart beta strategy would be expected to remove stocks from an index that are no longer showing strength. This would be done in hopes of locking in a profit and avoiding material loss, while adding stocks that are demonstrating strong momentum relative to their peers.
- The most straightforward smart beta strategy is equal weighting, which involves creating equal sector exposure at the time of rebalance.
Smart beta strategies are rebalanced and reconstituted on a periodic basis. Depending on the methodology, rebalancing and reconstitution may occur quarterly, semi-annually or annually. By contrast, market-cap investing causes investors to ride the ups and downs of sectors within a market-cap-weighted index.
Investors interested in alternatives to market-cap exposure may wish to explore Invesco’s full lineup of smart beta solutions.
1 Since ordinary brokerage commissions apply for each buy and sell transaction, frequent trading activity may increase the cost of ETFs.
2 Source: Bloomberg L.P., July 18, 2017. SPDR S&P 500 ETF Trust, iShares Core S&P 500 ETF, Vanguard S&P 500 ETF and Schwab US Large-Cap ETF were used to proxy inflows into benchmark-index-based ETFs.
3 Source: FactSet Research Systems, as of June 30, 2017
Blog header image: Brian A Jackson/Shutterstock.com
Standard deviation measures a portfolio’s or index’s range of total returns in comparison to the mean.
The S&P 500 Information Technology Index includes stocks in the S&P 500 Index classified as information technology companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The S&P 500 Energy Index includes stocks in the S&P 500 Index classified as energy companies based on the Global Industry Classification Standard methodology.
The S&P 500 Financials Index includes stocks in the S&P 500 Index classified as financial companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The S&P 500 Consumer Discretionary Index includes stocks in the S&P 500 Index classified as consumer discretionary companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The S&P 500 Consumer Staples Index includes stocks in the S&P 500 Index classified as consumer staples companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The S&P 500 Industrials Index includes stocks in the S&P 500 Index classified as industrial companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The S&P 500 Materials Index includes stocks in the S&P 500 Index classified as materials companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The S&P 500 Utilities Index includes stocks in the S&P 500 Index classified as utility companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The S&P 500 Health Care Index includes stocks in the S&P 500 Index classified as health care companies based on the Global Industry Classification Standard methodology. The index is market-cap weighted.
The Global Industry Classification Standard (GICS) was developed by and is the exclusive property and a service mark of MSCI Inc. and Standard & Poor’s.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The fund’s return may not match the return of the index.
Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
Beta is a measure of risk representing how a security is expected to respond to general market movements. Smart beta represents an alternative and selection-index-based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both, in active or passive vehicles. Smart beta funds may underperform cap-weighted benchmarks and increase portfolio risk.
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.
A momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole or returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
Shares are not individually redeemable, and owners of the shares may acquire those shares from the fund and tender those shares for redemption to the fund in creation unit aggregations only, typically consisting of 10,000, 50,000, 75,000, 100,000 or 200,000 shares.
Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the funds, call 800 983 0903 or visit invesco.com for a prospectus/summary prospectus.
Senior Equity Product Strategist
Nick Kalivas is a Senior Equity Product Strategist representing Invesco’s exchange-traded funds (ETFs). In this role, Nick works on researching, developing product-specific strategies and creating thought leadership to position and promote the smart beta* equity line up.
Prior to joining Invesco, Mr. Kalivas spent the majority of his career in the futures industry, delivering research, strategy and market intelligence to institutional and high net worth clients centered in the equity and interest rate markets. He was a featured contributor for the Chicago Mercantile Exchange, and provided research services to a New York-based global macro commodity trading advisor where he supplied insight on equities, fixed income, foreign exchange and commodities. Nick has been quoted in the Wall Street Journal, Financial Times, Reuters, New York Times and by the Associated Press, and has made numerous appearances on CNBC and Bloomberg.
Nick has a BBA in accounting and finance from the University of Wisconsin – Madison and an MBA from the University of Chicago Booth School of Business with concentrations in economics, finance, and statistics. He holds the Series 7 and Series 63 registrations.