New Indexes May Boost ETF Investors' Risk
Designs with fewer holdings seen as more perilous: Morningstar.
Investors may be taking on more risk than they realize as indexes continue to trim holdings and use more alternative weighting strategies than ever before.
According to a new research paper from Morningstar Inc., the composition of indexes has changed drastically in the past two decades. In the 1990s, indexes tracked a broad index and almost exclusively used market weight capitalization.
Now, a higher percentage of new indexes have less breadth, fewer holdings and use alternative weighting methods. For comparison, 85% of indexes weighted holdings by market cap in 1998, but that figure is only 42% today.
The researchers found passive ETFs following indexes with fewer holdings functioned similarly to active ETFs, because the indexes held so few stocks and used other weighting methods like equal weighting, dividends and fundamentals, and optimization.
Morningstar analyst Daniel Sotiroff pointed to the rise of thematic funds, ESG and other industry trends as reasons for more variability in index fund structures: “You can't just keep recreating the Russell 1000 Value, you have to somehow differentiate yourself.”
Higher-Risk Indexes
Parsing the risk of a fund’s underlying index can also be complicated for investors because indexes usually have limited live performance data. Morningstar found that index funds, once they go live, often don’t perform as well as they had in tests.
“A typical index’s backtested performance looks great, but it usually fails to live up to those historical expectations once it goes live,” the Morningstar report said. “Indexes tend to experience a drop in performance after a fund starts tracking them.”
Sotiroff said the disparity in expectations may be because index providers are using data mining techniques to create indexes: “They're building indexes around rules that perform well historically, but that doesn’t necessarily mean they’ll perform well in the future.”
According to Morningstar data, the vast majority of index tracking funds, including ETFs, wait less than a year to launch a fund tracking an index. The median index has only existed for about four months before it is adopted by an index fund or ETF, according to the data. Sotiroff said while the reasons behind the delay is unclear, one factor may be the time required to file documents with the SEC.
The study found that broad-exposure indexes tended to attract the most money after their launch because of low fees. The iShares Core S&P 500 ETF (IVV) and the Invesco S&P 500 Low Volatility ETF (SPLV) were both examples.
Contact Lucy Brewster at [email protected] or on Twitter at @lucyrbrewster