Investing Country-By-Country? Be Choosy With ETFs

The recent fallout in response to the United Kingdom's referendum vote on breaking ties with the European Union revealed the potential pitfalls international stock exchange traded fund investors face as traditional market capitalization-weighted country and sector exposure may leave investors open to unnecessary risks.

"Brexit shows benefits of sector and country ETF diversification," Michael J. LaBella, Portfolio Manager at QS Investors, told ETF Trends in a call.

The majority of exchange traded funds track traditional benchmark indices, which typically employ a market capitalization-weighted methodology where the largest companies have the biggest weights within the index. Consequently, in the case of international stock ETFs, these traditional market cap-weighted index funds may have large exposures to specific countries and sectors.

The common use of investing based on capitalization-weighted indices may be flawed and potentially expose investors to unintended risks or to missed opportunities.

For instance, many have looked to the MSCI EAFE Index as the benchmark for global developed overseas exposure. The index tracks developed economies out of European, Australasia and Far East. However, the index and related funds that utilize the benchmark included a hefty 18.6% tilt toward the United Kingdom, the second largest country weight in the index, and a 22.2% position in financials.

"I think our topic for today's call just became more obvious with Brexit," Rick Genoni, Managing Director and Head of ETF Product Management at Legg Mason, said. "A very clear tie in to why macro diversification matters."

As we recently witnessed, British equities were among the worst performing global markets and financials were the worst performing sector in the wake of the Brexit fallout.

“Using conventional passive, index-based investing as the center of a balanced investment strategy can introduce unexpected – and unwanted – volatility into a supposedly conservative portfolio, at just the moment when investors may be seeking refuge,” according to Legg Mason

Alternatively, ETF investors may consider smart-beta or alternative index-based strategies that follow customized indices as a way to focus on quality, diminish exposure to riskier areas, diversify across developed countries and potentially generate improved risk-adjusted returns over the long haul.

For example, the Legg Mason Developed Ex-US Diversified Core ETF (NASDAQ:DDBI) implements QS Investors’ proprietary Diversification Based Investing (DBI) rules-based methodology to help balance risk and deliver broad market exposure. DDBI's underlying index breaks down the universe of securities into investment categories based on sectors and countries. The five-year return patterns of the countries and sectors are taken to uncover relationships – areas that behave alike or differently. The underlying index then combines investment categories with more highly correlated historical performance into smaller number of so-called clusters, which are categorized based on tendency to behave similarly, or show various correlations. Each of these clusters are then equally weighted individually and also equally weighted across the portfolio to produce a diversified investment strategy.

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Consequently, through the DBI approach, the group of global stock ETFs should exhibit low correlation of excess return to active stock managers and traditional market cap-weighted indices. The DBI methodology also helps diminish concentration risk within country and sector exposures.

For instance, DDBI's top country weights include Japan 17.7%, Australia 8.0%, Canada 7.9%, U.K. 6.9% and Hong Kong 6.2%. Top sector tilts include financials 13.6%, industrials 12.3%, telecom services 11.4%, consumer staples 9.7% and consumer discretionary 9.6%.

With the greater diversification benefits found in the new breed of smart-beta, factor-based ETF strategies, investors can diversify their global exposure and diminish potential drawdowns in certain areas of the market as a result events like the Brexit.

"You can't predict these events," LaBella added, referring to the Brexit outcome. "People think the best thing you can do is pull away because you are afraid. Don't leave equities. Instead, be smart with stocks."

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