ETFs With a More Diversified Risk-Allocation Approach

Passive index funds have helped investors ride the extended rally in the equity market, but many now face concentration risks in an aging bull. Nevertheless, investors can turn to smart beta exchange traded fund strategies that try to address these downside risks.

For example, investors can look to funds like the Nationwide Maximum Diversification Emerging Markets Core Equity ETF (MXDE n/a) and the Nationwide Maximum Diversification U.S. Core Equity ETF (MXDU n/a).

“What makes our ETFs so different from Nationwide is that they address a problem a lot of investors are facing right now with concentration risk, but we answer that problem in a way that doesn’t involve putting on another bet. So investors can use us in a context of their current plan without changing that plan,” Patrick Gelshenen, Executive Director, TOBAM, said at the Morningstar Investment Conference.

The smart beta ETFs try to deliver higher risk-adjusted returns relative to market cap-weighted strategies by creating a more diversified risk allocation aimed at capturing the full equity risk premium.

Both funds track an index developed by TOBAM that applies liquidity and socially responsible investment (SRI) screens in determining the investable universe. Based on a patented, proprietary mathematical formula, the TOBAM Diversification Ratio, TOBAM weights individual stocks to minimize the correlations among holdings, resulting in the creation of the “most diversified portfolio,” given a 50% active share constraint.

The underlying 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.

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