Alternatives to market-cap ETFs

Market capitalization measures the share value of a public company with a simple algorithm of share price multiplied by total number of shares outstanding. This is a commonly used figure for rough stock valuation or even perceived net worth of a company.

For ETFs, many index the underlying stocks according to their market capitalization. But there are several alternatives to this approach, such as alternative indexing, fundamental indexing and smart beta.

There’s nothing new or wrong with these alternative strategies. They’re often simply a reweighting of an existing market-cap-weighted index, shifting risk exposure and potentially adding what’s known as active risk. They can generally be divided into two broad categories:

• Single-factor strategies. These include strategies that are weighted to maximize or optimize exposure to a particular characteristic (factor). The weights may have nothing to do with capitalization.
• Multi-factor market strategies. These include fundamental strategies that seek to weight stocks based not just on size, but also on firm size (employment), book value, cash flow, sales or dividends.

These alternative strategies are a response to the view that the market capitalization model (cap-weighting) gives too much weight to companies simply because of their large size or, worse, their overvalued stock.

Active managers and rules-based passive managers both believe they possess information not represented in the market cap of the stock. The result for many alternative rules-based equity strategies is they generally skew towards value and small-cap investing. And in the recent environment, where small-cap and mid-cap value have been outperforming, these bets have paid off.

But as we go through cycles, growth and large-cap may outperform again, and non-cap-weighted strategies may disappoint. Note that many of these strategies underperformed during the financial crisis because they were overweight financial stocks.

A bet against the market

Unlike a market capitalization-weighted approach, alternative strategies don’t enable you to own the market. Instead, they’ll either do better or worse. The trick in deviating from a cap-weighted market index is to find the investment manager or rule that puts you on the winning side. The risk is underperforming relative to the index or having a poor outcome given the portfolio’s specific exposures.

The search for outperformance has been the age-old objective of traditional active managers. If outperformance were as simple as coming up with some rules and investing accordingly, we’d expect to see a robust history of outperformance across the board. But that’s not something we have seen consistently.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.