Market-cap-based indexes have become a hit with investors in recent years, particularly due to their low cost and simplicity. And given their favourable exposure to a long-extended bull market, it should be no surprise that holding such ETFs has become a hard-to-kick habit for many.
But a survey of investors and financial advisors earlier this year suggests that there’s an upcoming and underestimated danger. “The research focused on low-cost ETFs that are designed to closely track a broad equity market index, such as the S&P 500,” wrote Invesco in a new commentary. “[It] revealed a disconnect between market expectations and portfolio allocations in market-cap-weighted strategies.”
In a previous study, the company had found an expectation of two to three more market adjustments in 2018, along with an anticipated 20% market decline by year’s end. Investors and advisors polled had also reported that they foresee a recession by 2021.
“Yet, despite this tempered outlook, advisors continue to recommend that up to 44% of a client’s portfolio should be allocated to bulk beta (market-cap) ETFs,” the company said, noting that such strategies are directly exposed to potential volatility and market downturns.
The study also found a disjoint between clients’ understanding of market-cap strategies and advisors’ estimation of that understanding. The advisors Invesco polled said 57% of their clients generally understand the product, but 74% of advised investors reported that they are not familiar with market-cap ETFs, even when given detailed explanations.
“More than 60% of investors were unsure how much of their portfolio is dedicated to bulk beta ETFs — and among those who knew, 24% seems to be the average percentage of an investor’s portfolio allocated to bulk beta ETFs,” Invesco added.
In addition, 70% of investors who said they were familiar with market-cap ETFs said they were lower-risk than mutual funds. “In contrast, most advisors (72%) view bulk beta ETFs to be just as risky as other funds,” the company said, noting that more than one-quarter of advisors present market-cap strategies as low-risk ways to match the market’s performance.
The company’s survey also revealed that advisors who foresee a major market disruption in 2018 are more likely to present market-cap ETFs as low-risk during client conversations, while those who foresee no disruption are more likely to pitch them as low-cost.
“More advisors who present bulk beta ETFs as low risk agree that they struggle with risk aversion, client expectations and convincing their clients to stay in the market during periods of high growth as compared to those who emphasize the low cost,” Invesco said. “To avoid misconceptions, advisors may be better served by highlighting the low cost of bulk beta ETFs rather than presenting them as low risk.”
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