Investors interested in the long-term capital appreciation potential of stocks may be attracted to funds that offer total equity market exposure. Many broad market funds track market-weighted indices, however, which may create concentrations in the largest stocks. This concentration can mean that portfolios may miss out on the historic growth opportunities sometimes found in small-cap and value stocks.
In this paper, we explain why a portfolio that maintains exposures to small-cap and value stocks has the potential to outperform a portfolio that only follows a market-weighted index. We then describe the index approach behind the FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT), which is designed to provide broad equity market exposure with a tilt toward small-cap and value stocks.
THE POTENTIAL IMPACT OF CONCENTRATION IN THE LARGEST STOCKS
Investors may look to broad equity markets for their potential to generate long-term capital appreciation. ETFs and mutual funds that track market indices designed to reflect the total equity markets have provided investors a convenient vehicle to gain broad equity market exposure. These indices are usually market-weighted, however, which means the number of shares they hold in any particular company is directly related to the size of that company’s market capitalization.1 As a result, big companies with pricier stocks may make up a greater proportion of the shares in a fund that matches an index following that approach.
As a result of this large-cap concentration, these portfolios may produce lower returns than the overall market they’re attempting to reflect. The reason: They may miss out on the growth potential from small-cap and value stocks. Landmark research produced in the early 1990s by Eugene F. Fama and Kenneth R. French demonstrated that exposure to small-cap and value stocks produced consistently better long-term returns than following a market-weighted index.
What’s more, we believe an overconcentration in large-cap stocks may put a portfolio at greater risk of stock market bubbles. When a bubble forms in a sector or group of stocks, investors may bid up the prices of those stocks and potentially inflate their overall market value. In turn, those stocks may then take up a greater portion of a market-weighted index—increasing the potential risk of steeper-than-market declines if, and when, a bubble were to burst.
To help meet investors’ goals for potential returns while managing risk, we believe a total market portfolio should judiciously maintain exposure to small-cap and value stocks while continuing to provide large-cap exposure.
A MULTI-FACTOR APPROACH TO INDEX CONSTRUCTION
The FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT) is an ETF that seeks long-term capital appreciation by tracking a custom index, the Morningstar U.S. Market Factor Tilt Index.2
The index starts with a broad universe of U.S. stocks that trade on the New York Stock Exchange, NASDAQ stock exchange, or the NYSE Market LLC. Stocks are then defined and divided by current market capitalization when Morningstar applies a multi-metric valuation analysis to determine appropriate style categorization. Based on those two filters, each stock in the index is assigned to one of 12 boxes corresponding to their size and style:
Morningstar then constitutes the index with an intentional tilt toward small-cap and value stocks. For example, the index will reduce weight in the large-cap growth and large-cap core boxes to increase weight across the smaller and value portions of the index.
To maintain this tilt, Morningstar makes adjustments on a quarterly basis. Twice a year, June and December, it reconstitutes the index to account for any shifts in the market that affect the size and style of the stocks in the investable universe. In March and September, Morningstar rebalances the index to ensure it stays within the parameters established in June and December.
BROAD MARKET EXPOSURE PLUS THE POTENTIAL TO CAPTURE SMALL-CAP AND VALUE PREMIA
By starting with the broadest possible universe of U.S. stocks, we believe Morningstar’s selection process offers investors the exposure they seek when pursuing the long-term capital appreciation potential of equities. By tilting toward small-cap and value stocks, the index seeks to capture the potential for long-term return premia offered by those categories—which may be missed in traditional market-weighted indices.
Our research suggests exposure to both small-cap and value stocks may provide benefits because of the potential low correlation between the factors. A portfolio that tilts toward both small-cap stocks and value stocks may capture outperformance in one factor, even when the other underperforms. At the same time, we believe maintaining exposure to large-cap stocks may reduce tracking error versus the overall market compared to investment products that make larger bets on small-cap or value stocks.
Portfolios modeled on market-weighted indices seek long-term capital appreciation by tracking the performance of broader equity markets. But market weighting may make these types of indices vulnerable to concentration in the largest stocks. Our opinion is that portfolios that track them may potentially miss out on the investment benefits provided by smaller stocks and value stocks.
The FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT) is intended to provide deep exposure to the investable U.S. equity universe while potentially providing investors a vehicle to track the performance of the broad U.S. equity market. Strategic reweighting in the underlying index then is designed to provide a tilt toward the small-cap and value stocks that other market-weighted indices may have historically missed. The resulting fund seeks to reflect the experience of investing in the broad equity market, while reducing the risk of overconcentration in large-cap stocks and pursuing the excess return potential from the value and small size factors.
1 Market capitalization refers to the total dollar market value of a company’s outstanding shares of stock. Commonly referred to as “market cap,” it is calculated by multiplying the total number of a company’s outstanding shares by the current market price of one share.
2 The Morningstar U.S. Market Factor Tilt Index is an index designed to provide deep exposure to the broad U.S. equity market while seeking to take advantage of the persistent, longer-term small-cap and value performance premiums.