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A tune-up for your equities portfolio

Does your index (or equities allocation) need a tune-up? Increasingly, investors are becoming aware of the inherent limitations of market capitalization weighting, which simply uses the total market value of a firm's outstanding shares as a means to weight individual components in the index. Cap weighting is the most prevalent methodology for index construction and the very same scheme used by the S&P 500® Index. However, it often results in a heavy tilt to the largest companies, discounting the performance and contribution of the smaller constituents. Such mega-cap dominance may garner little attention at times when the largest companies excel and grow more rapidly than the average stock, as in recent years. But when the momentum runs out and mega caps fall out of favor, any product built around a cap-weighted index could suffer.

Given this reality, other index approaches have come to the forefront. One of these is a simplistic equal-weighting approach, whereby the stock index allocates equally to all constituents giving no regard to size or risk. In the S&P 500 Equal Weight Index,® for example, every company’s allocation is fixed at 0.20% (quarterly). This seems to be a naive attempt at diversification. On one hand it solves for concentration risk and mitigates some of the sector and large-company biases of traditional cap weighting. But it also ratchets up the total portfolio risk profile by over-allocating to smaller companies, which historically tend to be more volatile than their large company counterparts over time.

Investing explicitly to achieve low volatility is another popular, if dubious, approach. Limiting the universe of an index solely to lower-volatility stocks can naturally result in a lower-volatility portfolio, but it hardly provides for broad diversification. Is a portfolio full of consumer staples, utilities, and other defensive sectors an ideal, all-weather approach? Maybe not.

Ultimately, we believe that volatility weighting—giving larger weights to less volatile stocks, and smaller weights to more volatile stocks—may be a more intuitive way to build an equities index. Volatility weighting aims to equalize the volatility contribution across the entire portfolio and, by consequence, equalize the risk contribution of each constituent. Equalizing risk contribution seems like a smarter objective because it gives every stock a voice and may help create a portfolio built to perform consistently over a full market cycle.

Below is a table that provides information on five popular index methodologies and summarizes their objectives and potential limitations. Choose wisely.

Under the hood table

 

Diversification and volatility weighting do not assure a profit or eliminate the risk of loss.

This material should not be construed as a recommendation or advice for any security. An index is unmanaged and not available for direct investment; therefore its performance does not reflect the expenses associated with the active management of an actual portfolio.

The views are as of the date published and are subject to change. This material is provided for informational purposes only and may not be used or construed as investment advice or a recommendation to take any particular investment action. There is no guarantee that the information supplied is accurate, complete, or timely.

©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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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.

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