An Equity ETF Strategy to Max Out Diversification

ETF investors seeking to enhance their portfolio mix can consider a smart beta strategy based on a TOBAM methodology that challenges conventional diversification wisdom. In the recent webcast, 99 Problems, but Concentration Isn’t One: A New Approach to Diversification , Mark Hackett, Chief of Investment Research, Nationwide, outlined the current market environment we are in after a tough coronavirus induced pullback and subsequent rally in equities.

Source: An Equity ETF Strategy to Max Out Diversification

Looking ahead, Hackett highlighted the importance of earnings to the continued rally.

Meanwhile, supportive factors will help maintain the upward momentum and fuel growth ahead. For example, government policy remains accommodative on both the fiscal and monetary sides.

Investors, though, have become anxious in light of rising rates as yields on benchmark 10-year Treasury notes quickly jumped to one year highs over a one month period. Nevertheless, stocks haven’t been troubled by big interest rate jumps in the past. Looking at historical data since 2003, the S&P 500 has still returned an average 18% over a one-year period after large moves in the 10-year Treasury yield.

Hackett also underscored a number of factors that will continue to maintain market growth ahead, including tailwinds like fiscal stimulus, monetary stimulus, improving economic conditions, improving earnings growth, political clarity, coronavirus case reductions, vaccine rollouts, and improving equity flows.

Dr. Tatjana Puhan, Managing Director, Deputy Chief Investment Officer, TOBAM, argued that investors should separate the myths from the facts when navigating the markets, especially in addressing long-term diversification. For starters, she believes that passive investments do not necessarily translate to neutral investments since using a biased market cap-weighted benchmark as a reference may carry heavy and potentially costly implicit bets, which tend to evolve dynamically over time. For example, the information technology component of the S&P 500 made up 34% of the benchmark index at the height of the dot-com bubble while financials made up 34% of the benchmark during the global financial crisis. Puhan warned that market cap-weighted benchmarks are hugely biased.


“Market cap-weighted indexes tend to attribute greater representation to stocks or factors as they appreciate and less representation as their prices decline – the greater the imbalance, the greater the impact of price changes,” Puhan said. “The better a stock or factor has performed in the past, the greater the propensity to overweight these past winners which necessitates greater outperformance of these positions – betting on past winners is speculation, not diversification.”

Puhan advised investors to look more closely at correlation of holdings rather than just focusing directly on specific holdings. All the independent risk factors present in the market are represented in the portfolio, even if the portfolio has no position in a given stock or sector.

Puhan also pointed out that investors should reconsider risks in tracking errors. Tracking error measures the distance between two portfolios. It is a relative measure, not an absolute measure of risk, hence it depends on the basis of comparisons. Tracking errors do not measure economic capital risk, drawdown risk, and concentration risks.

“Comparing a portfolio to a market cap-weighted index may consequently make a portfolio that does not have the same extreme bets as the market cap-weighted portfolio appear ‘risky’ even if the opposite is true,” Puhan said. “There are plenty of studies that show that by focusing on tracking error as a risk measure, portfolio managers have little incentive to build portfolios that really are ‘better’ than the extremely biased cap-weighted portfolio.”

Lastly, Puhan warned that multi-factor investing is not inherently smarter. It is hard to define factors, so academia and industry have proposed a number of different factors over the last few decades.

As a way to better-diversify risk, Nationwide has partnered up with TOBAM in providing the Nationwide Maximum Diversification U.S. Core Equity ETF (NYSEArca: MXDU), a “smart” way to diversify for U.S. market exposure.

The Nationwide Maximum Diversification U.S. Core Equity ETF tries to reflect the performance of the TOBAM Maximum Diversification USA Index, a diversified rules-based index of large- and mid-sized U.S. companies that uses a quantitative model to weight companies to maximize the TOBAM Diversification Ratio of the index. The TOBAM Diversification Ratio is a patented, proprietary metric based on the volatility of each index constituent and its correlation to other constituents.

The underlying process screens against a socially responsible investment exclusion blacklist to exclude those involved with the production or sale of unconventional weapons, production of tobacco, production of coal or coal-based energy, serious or systematic human rights violations, severe environmental damage, gross corruption, or other particularly serious violation of ethical norms. The index then analyzes the volatility and correlation of each component and weights them to maximize the Diversification Ratio.

Financial advisors who are interested in learning more about smart beta strategies can watch the webcast here on demand.