Drawdown reveals risks in widely used ETFs, indexes

Warning: Concentration risk. Indexes exposed!

Hardly the stuff of tabloids, every decade or so market volatility reveals features of popular equity and fixed-income indexes that may catch even the most sophisticated index investors off guard. This year, the confluence of inflation, rate hikes and slowing growth have highlighted the risks embedded in market or cap-weighted stock and bond funds and boosted the profiles of exchange-traded funds that can be used to mitigate the biases in mainstream indexes.

For institutional investors, broad-based index ETFs serve the very useful purpose of liquidity and transition management, and even core holdings for some.

But leave it to a down market to reveal blemishes that investors ignored on the way up. In float-adjusted, market cap-weighted equity indexes, valuation and concentration risks were revealed. For market-representative fixed-income indexes, those risks were extended to credit quality and duration.

The twin pullback of the S&P 500 and the Bloomberg U.S. Aggregate indexes has created a surge of interest in products that allow for differentiated risk management. For stocks, that's alternate weighting as well as factor-based offerings. On the debt side, term-maturity, target-duration and credit risk ETFs are attracting new dollars.

"At $6 billion through October, it's been a record year for flows into iBonds," said Dhruv Nagrath, director, iShares fixed-income product strategy at BlackRock Inc. in New York.

IBonds and BulletShares from Invesco Ltd. are diversified bond portfolios packaged as ETFs that offer exposure to Treasuries, emerging markets, and investment-grade and high-yield corporates and munis with annual maturities going out as much as 10 years. The ETFs make monthly distributions and "mature" annually, paying out par value upon expiration.

Mr. Nagrath said BlackRock is also fielding more interest in targeted credit risk products compared to its widely used bond benchmark ETFs tracking the Bloomberg Aggregate or the iBoxx investment-grade and high-yield indexes.

Targeted credit fixed-income ETFs allow investors to pinpoint those risks that are not adjusted for in broad-based bond indexes. For example, the credit profile in the $35 billion iShares iBoxx $ Investment Grade Corporate Bond ETF, or LQD, shifted lower over the past decade as tech firms joined the debt market.

Investors looking to avoid the nearly 50% weight of BBB corporate bonds in LQD could move to a product such as the iShares Aaa-A Corporate Bond ETF, or QLTA. Shares of LQD declined 21.9% through Nov. 3, according to ETF.com, compared to 18.8% for QLTA.

As in any rate tightening cycle, longer-duration bond portfolios will decline, but what a lot of bond index investors may be less aware of is the extent to which the duration of an index can change over time. For example, duration in LQD peaked around 10 years in 2020 and has since dropped to roughly 8. Even duration in the more stable Bloomberg Aggregate approached 7 last year after hovering around 5 for most of the prior decade, according to data provided by BlackRock.

Over the past few months, several new ETF products have come to market that can serve to better target duration. In September, BondBloxx Investment Management Corp. launched targeted duration Treasury ETFs (from six months to 20 years) and F/m Investments LLC introduced bond ETFs that invest only in certain on-the-run Treasuries. Of course, such products are most useful for investors who prefer to access their debt investments on exchange, as opposed to direct investment.

On the equity side, alternative-weighted products are far more established. Equity ETFs that target sectors or factors provide institutional investors a wide range of ways to sway from the embedded valuation and concentration risks in a cap-weighted, float-adjusted broad market index.

"We've found that investors are looking for an S&P 500 exposure that is not as concentrated as we've seen in recent years," said Nick Kalivas, head of factor and core equity product strategy for Invesco in Chicago. "The knocking down of megacap growth stocks has highlighted the risk inherent in cap-weighting."

For example, information technology currently comprises 25% of the S&P 500 by valuation. That was as low as 11% in 2013. Financials, once 20% in 2002, are now just 11%.

The simplest products for managing valuation and concentration risk in equities are also some of the oldest "alternative" ETFs in the market. For example, the $32 billion Invesco S&P 500 Equal Weight ETF will celebrate its 20th anniversary in April, and investors have shifted $4.2 billion into the fund this year. (Cap-weighted S&P 500 sector funds are even older, but can actually magnify single-stock risks. These products are often utilized by more tactical investors looking to overweight/underweight sectors relative to the S&P 500.)

Equal-weight sector funds as well as equal-weight ETFs on other broad-based indexes have not garnered as much investor interest or assets. Invesco's Mr. Kalivas said that investors are more drawn to its S&P 500 equal-weight product where "concentration risk is far greater."

Also available are modified-weighting equity ETFs from Syntax Advisors LLC that attempt to even out related business risk.

"There's no right answer for a benchmark index," said Craig Lazzara, managing director in the core product management group for S&P Dow Jones Indices in New York. "It depends on what the object of the index is. If you are looking to measure the totality of the U.S. stock market, then a comprehensive, cap-weighted, float-adjusted index will capture that. If you want to understand the performance of the average stock, then an equal-weight index can be used as a benchmark."

This year's declines in both debt and equity markets may also offer pension and endowment funds the opportunity to revisit their benchmarking practices altogether, Mr. Lazzara said.