"These are index or rules-based investments and you have a high degree of certainty what you’ll be holding, so you can’t blame this one on the underlying active manager."
In terms of sectors, for broad, market-cap-weighted indices, he says most investors should already know where the exposures tend to be – the US has a lot in technology, the UK has a lot in financials and basic materials, for example.
And this is where using an adviser to find ETFs that provide a different level of diversification comes into play, he adds.
"These can be supplemented, for example, with dedicated sector ETFs to control overall sector exposure."
This goes some way to answering the correlation/concentration conundrum, according to WisdomTree's Debru. He comments: "Can ETFs be structured/selected to help avoid concentration risk in any one sector?
"Looking at global equity markets, there is no denying that market-cap-weighted indices have gone through a period of concentration. US equities represent almost 70 per cent of developed, equity market-cap-weighted indices.
"The top five stocks in the S&P 500 represent north of 20 per cent of the index. However, not all ETFs are passive; not all ETFs are market-cap weighted."
Because many ETF providers specialise in strategies that seek to outperform the market or products that unlock new or hard-to-access exposures.
Debru highlights Factor ETFs (also called smart beta) as one solution for the "concentration risk conundrum". He explains: "Such ETFs provide exposure to diversified research-grounded strategies with a focus on long-term outperformance.
"By construction, those ETFs select stocks based on differentiated factors, like companies’ profitability or their growth potential and therefore tend to offer differentiated exposure to investors, away from the largest stocks in the world."
Furthermore, many of those ETFs have inbuilt sector and country caps leading to less concentrated exposures. Thematic ETFs are also a very good way to avoid concentration in mega caps, he adds, as these aim to harness long-term growth by turning mega-trends into investment opportunities, breaking out of traditional silos, such as countries, sectors, factors, or regions.
Client centric
It might be worth advisers reminding clients that some of the non-market-cap-weighted indices (not all) can change the sector mix as well.
For example, since it is often the mega-cap stocks that dominate sector weights, using an equal-weighted index (effectively giving them exposure to size factor effects) will often also reduce some of the high sector exposures.
Back in 2013, Cass Business School ran an extensive study, commissioned by Aon Hewitt, to explore the make-up of indices and whether alternative approaches to index creation would be better for passive investors.
