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Don't skip lunch: It's time to put risk-weighting on your menu

It’s time to put risk-weighting on your menu. After all, diversification is widely considered “the only free lunch in investing.”

Nobel prize-winning economist Harry Markowitz once quipped that diversification is “the only free lunch in investing.” Isn’t it ironic, however, that in challenging periods and at times of market extremes, some investors question the benefits of diversification? 

That’s our current environment, and that’s exactly why we continue to advocate for strategies that are disciplined in how they spread risk. This is especially important for any core equity allocation. So to those investors who have been allocating to products that track the cap-weighted S&P 500® Index and have benefitted from the recent tailwind provided by mega-cap stocks—congratulations on your fortuitous timing. Now be wary. 

Culminating in 2018, the S&P 500 had become a de facto outsized bet on a handful of mega-cap stocks—specifically technology companies—that dictated the performance of the index. But if history is any guide, investors might want to reconsider such an allocation given current levels of dangerous concentration and what typically transpires after we reach these extremes. 

Market-cap weighted indexes are built by weighting individual constituents by size. The larger the constituent becomes, the more it influences overall performance. In 2018, the top stocks of the S&P 500 were dominating the index, and the extreme levels of concentration not seen since the dot-com bubble were elevating its risk profile. In fact, we would argue that the S&P 500 is really just a concentrated bet that is more suited as a tactical play on mega-caps as opposed to a core holding.

Look ahead, not behind
Concentrated pockets of leadership within the stock market are fickle. Remember the“four horsemen in 1999?” The energy sector and financials have also taken their turn with outsized influence in the S&P 500. And most recently the FAANG stocks (plus Microsoft) have enjoyed the limelight. The point is, no one knows exactly when the current leaders revert, but they almost certainly will. It is better to spread risk evenly across all constituents for a core equity allocation as opposed to making a concentrated bet on a few mega caps that fall in and out of favor. 

The adjacent graph should be a cause for concern for anyone allocating to the S&P 500. Don’t invest based on what happened last year (or any single year), but rather look ahead and consider how an allocation might perform over the next two to three years, and far beyond.

4Q2018_Trailing1Year


Looking at the current situation, it appears that a cap-weighted benchmark like the S&P 500 may be vulnerable to a period of underperformance relative to a more diversified approach. Investors in the S&P 500 should be looking forward given the recent levels of performance concentration and wonder if and when we will see a reversion.

Seeking true diversification 
For those investors who are considering an equal-weighted index methodology for their large-cap allocation, we would suggest thinking twice. In fact, equal weighting the S&P 500, for example, naively over-allocates to smaller companies within that large-cap universe as a means to generate better returns. But equal weighting is inherently flawed because it extends risk in order to achieve a small performance bump, and there’s no guarantee it will be successful at that.

Rather, we think true diversification is the better approach. This may not be obvious every single year, but it may likely hold true over time. So if you believe you should own less FAANG, less concentration and be more diversified, it might be time to consider pivoting to a risk-weighted approach for your core equities allocation. We believe the VictoryShares solution—one that screens for consistent profitability and spreads risk more evenly across the portfolio—is appropriate for the long haul, not only for large-cap domestic stocks, but also across small caps, emerging markets, and international equities. 
 

Past performance is no guarantee of future results.

Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.

Certain views expressed are the author’s, are subject to change without notice, and may differ from those of Victory Capital, Inc. Information and opinions are derived from proprietary and nonproprietary sources deemed to be reliable; the accuracy of those sources is not guaranteed. This material does not constitute a distribution, offer, invitation, recommendation, or solicitation to sell or buy any securities; it does not constitute investment advice and should not be relied upon as such.

Nasdaq is a registered trademark of Nasdaq, Inc. and its affiliates (together, “Nasdaq”) and is licensed for use by Victory Capital. The product(s) are not issued, endorsed, sold, or promoted by Nasdaq. Nasdaq makes no warranties as to the legality or suitability of, and bears no liability for, the product(s). Nasdaq is not affiliated with a fund or advisor.

A fund’s portfolio differs significantly from the securities held in an index. An index is unmanaged and not available for direct investment.

The Nasdaq Victory US Large Cap 500 Volatility Weighted Index consists of 500 of the largest U.S. stocks with consistent positive earnings. These stocks are then weighted based on their standard deviation (volatility). The S&P 500® Index is a market capitalization-weighted index composed of the common stocks of 500 leading U.S. companies.

©2019 Victory Capital Management Inc.

Consider the investment objectives, risks, charges and expenses of the funds carefully before investing. Download a prospectus or summary prospectus, if available, containing this and other important information for USAA mutual funds from www.usaa.com/prospectus, for Victory mutual funds from www.victoryfunds.com, or for VictoryShares and VictoryShares USAA ETFs from www.victorysharesliterature.com. Read it carefully before investing.

Investments involve risk including possible loss of principal. The value of the equity securities in which the fund invest may decline in response to developments affecting individual companies and/or general economic conditions. Dividends are never guaranteed. International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty, and greater volatility. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. You may lose money by investing. There are no guarantees the funds will achieve their investment objectives and strategies may be unsuccessful.

Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

ETFs have the same risks as the underlying securities traded on the exchange throughout the day. Redemptions are limited and often commissions are charged on each trade, and ETFs may trade at a premium or discount to their net asset value. There can be no assurance that an active trading market for shares of an ETFs will develop or be maintained. The ETFs are not actively managed and may be affected by a general decline in market segments related to the Indexes. The ETFs invest in securities included in, the Index, regardless of their investment merits. The performance of the ETFs may diverge from that of the Indexes. 

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

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This material does not constitute a distribution, offer, invitation, recommendation, or solicitation to sell or buy any securities; it does not constitute investment advice and should not be relied upon as such.  Investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Victory Capital means Victory Capital Management Inc., the investment manager of the USAA Mutual Funds and VictoryShares USAA ETFs. Victory Mutual Funds and USAA Mutual Funds are distributed by Victory Capital Advisers, Inc. (VCA). VictoryShares ETFs and VictoryShares USAA ETFs are distributed by Foreside Fund Services, LLC (Foreside). VCA and Foreside are members of FINRA and SIPC. Victory Capital Management Inc. (VCM) is the investment adviser to the Victory Mutual Funds, USAA Mutual Funds, VictoryShares ETFs, and VictoryShares USAA ETFs. VCA and VCM are not affiliated with Foreside. USAA is not affiliated with Foreside, VCM, or VCA. USAA and the USAA logos are registered trademarks and the USAA Mutual Funds and USAA Investments logos are trademarks of United Services Automobile Association and are being used by Victory Capital and its affiliates under license.

Nasdaq is a registered trademark of Nasdaq, Inc. and its affiliates (together,“Nasdaq”) and is licensed for use by Victory Capital. The product(s) are not issued, endorsed, sold, or promoted by Nasdaq. Nasdaq makes no warranties as to the legality or suitability of, and bears no liability for, the product(s). Nasdaq is not affiliated with a fund or advisor.

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