Individual stock pickers rarely beat the market over the long term1—which can make a compelling case for investing in index mutual funds and exchange-traded funds (ETFs). What’s more, a single index fund can provide exposure to hundreds if not thousands of stocks, ensuring you’re not overexposed to the ups and downs of any one security.
Be that as it may, many broad-market index funds—including those that track the S&P 500® Index—aren’t nearly as diversified as you might think. That’s because their underlying indexes are often capitalization weighted, meaning they weight each stock according to the total market value of its outstanding shares. In other words, if the total market value of Microsoft’s outstanding shares were 10 times that of Nike’s, the technology company would have 10 times more influence on the index’s performance than the activewear company.
Thus, the capitalization-weighted approach contains a hidden risk: A few large companies can come to dominate an index’s overall value (and hence its performance). The top 10 companies in the S&P 500, for example, represent only 2% of the stocks in the index but approximately 22% of its value (see “Outsize influence,” below).
Source: S&P Dow Jones Indices, as of 11/29/2019.
This potential for overexposure to a handful of market behemoths has helped give rise to alternative weighting methods, which determine a company’s influence on an index using metrics other than market capitalization. “Investors are recognizing that there are drawbacks to investing proportionate to market cap alone,” says Steve Greiner, senior vice president of Schwab Equity Ratings®.
Beyond cap weighted
One alternative methodology—called equal weighting—is to hold all the stocks in an index in equal amounts; hence, as some companies rise in value, a portion of their shares are sold and the money reinvested in other companies in the index to maintain equal weighting. Other approaches focus on growth or value or volatility.
These alternative weighting methodologies—known collectively as “strategic beta”—account for about 17% of U.S. equity index fund investments.2 “Strategic beta is where we’re seeing some of the largest growth in the ETF industry,” Steve says.
Most strategic-beta funds may offer some degree of diversification and complement the cap-weighted funds many investors tend to hold, but investors might find certain strategic-beta funds more suited to their investment goals than others.
So, how can you determine which alternative indexing methodologies are right for you? Let’s break down seven common strategic-beta approaches—and the investors to whom they may appeal.
- What it is: A mix of stocks weighted by the highest-dividend payers, typically based on the aggregate dollar amount of each company’s dividends or other approach tied to payouts.
- Who it’s for: These funds are often favored by investors who are nearing retirement and shifting their focus from growth to income generation. Because equities with strong and rising dividends have in recent decades outperformed their low- and non-dividend-paying counterparts, they might also appeal to any investor looking to maximize her or his returns.
- What it is: These funds screen and weight stocks based on various financial metrics—such as their underlying companies’ cash flow, dividends, and sales. Fundamental strategies tend to outperform during the middle to late stages of an economic expansion, when growth becomes scarce and value becomes more important.
- Who it’s for: Because they are likely to be less volatile in down markets than, say, momentum funds (see next entry), fundamental funds may appeal to investors who want less exposure to the handful of highfliers that often dominate capitalization-weighted indexes. Even in appreciating markets, however, fundamental funds can complement traditional cap-weighted approaches because of their differentiated performance.
- What it is: These funds look to capitalize on an upward market trend by favoring stocks with the strongest price movements while avoiding those with the weakest price movements. Managers of momentum funds rebalance at regular intervals to reflect the latest price changes in their underlying indexes, which can generate a high degree of turnover in the fund’s holdings and hence inordinate capital gains.
- Who it’s for: Momentum funds might be right for investors looking to potentially boost their returns over the short term, especially during rising markets. That said, “momentum can change direction quickly, leaving investors whipsawed and with high turnover in their portfolios, which could trigger unexpected taxes,” Steve says. “For this reason, it’s wise to incorporate these funds in moderation.”
- What it is: Growth funds seek to amplify returns by giving more weight to stocks that exhibit superior growth characteristics. They score their component companies by such growth metrics as rapidly rising earnings and sales—irrespective of price trends.
- Who it’s for: This strategy may be appropriate for investors looking for better potential returns than those typically provided by traditional cap-weighted funds—and who are comfortable with the increased risk. Because you’re betting that the fastest-growing companies are going to continue to outperform the market, such funds could suffer if growth slows.
- What it is: Essentially the opposite of growth, these funds incorporate prices in determining how much of a discount a stock is trading at relative to fundamental characteristics such as book value, earnings, and sales. The bigger the discount, the greater the weight in the index.
- Who it’s for: Value funds can be especially attractive to those in or nearing retirement because they can provide steady returns without overexposing investors to high-flying, highly volatile growth stocks.
- What it is: A fund that favors companies that have historically delivered higher returns on equity, lower debt burdens, and steadier earnings.
- Who it’s for: Quality funds are mainly geared toward investors who want exposure to stable companies with a proven track record of stronger profits and prudent financial management, and who favor consistent performance over the potentially greater returns—and risk—of high-growth stocks.
7. Low volatility
- What it is: Funds in this category give more weight to stocks that have historically generated smaller price swings than the market as a whole over previous periods.
- Who it’s for: Because of their orientation toward lower-volatility stocks, such funds may be particularly appealing to those nearing retirement or who are otherwise concerned about their ability to wait out a market downturn. Be aware, however, that investing in low-volatility funds may also mean sacrificing potentially bigger returns during rising markets.
While momentum and pure growth funds can boost performance when growth stocks are leading the way, pure value and low-volatility funds may offer better protection when stocks slump. But does that mean you should use strategic-beta funds to respond to prevailing market conditions? “Only if you can accurately predict when to shift between styles—which is a tall order even for professional money managers,” says Mark Riepe, head of the Schwab Center for Financial Research.
Instead, Mark suggests a diversified approach—incorporating strategic beta as a complement to the cap-weighted funds many already hold. The good news, he says, is that “given the number and variety of methodologies available, most investors are sure to find one that fits their risk appetite and investment objectives.”
1Aye M. Soe, Berlinda Liu, and Hamish Preston, SPIVA® U.S. Scorecard, S&P Dow Jones Indices, 2018. | 2Morningstar, as of 08/31/2019.