Smart Beta 4: Factor Exposure's Curveball

April 22, 2014

By including factor tilts in smart beta’s definition, you get a mishmash of ETFs.

This blog is the fourth installment of a series transforming our ideas about smart beta. Part 3 showed that so-called alternative weighting serves many purposes, and fails an indicator of smart beta. Part 2 set the ground rules. Part 1 argued that defining smart beta in an ETF context is essentially impossible.

 

There is a strong movement to conflate smart beta with factor investing. For lots of folks, factor investing is the “smart” part of smart beta.

Circling back to our ground rules, sorting ETFs by factor exposure produces groupings that will cause rifts in the ETF community.

Factor investing targets specific drivers of returns. The most common factors are size, value, yield, momentum, volatility and quality. These factors show up in plain-vanilla indexes, of course, but can also be targeted and amplified, especially by index providers with huge databases and crafty analysts.

The past decade has brought us factor funds like the FlexShares Morningstar’s US Market Factor Tilt ETF (TILT | A-80) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-45). Older “smart” funds target factors too: value in PowerShares’ FTSE RAFI US 1000 (PRF | A-88), size in Guggenheim’s S&P 500 Equal Weight (RSP | A-75) and yield in iShares’ Select Dividend (DVY | A-67).

Designer funds promote the smart-beta label. However, branding all funds with factor exposure as smart beta will start arguments. In terms of our ground rules, sorting ETFs by factor exposure produces results that are not widely acceptable to the ETF community.

If factor exposure defines smart beta, then all funds with factor exposure must be smart beta. As you will soon see, most funds have some kind of factor exposure.

We might have to work a bit to define what “factor exposure” means, just as we had to transform “noncap-weighted” to “plain vanilla” back in part 2.

We could require a deliberate index-design process that targets factor exposure, with nonvanilla selection or weighting, too.

Even these nuanced definitions of factor exposure produce groups of funds that will not be widely acceptable within the ETF community.

Three groups of funds that have factor exposure but don’t seem like smart beta will prove that factor exposure doesn’t work as a smart-beta criterion.

  1. Cap-weighted (and selected) size and sector funds often have small-cap or value exposure.
  2. Cap-weighted (but not selected) value funds deliberately access the value premium.
  3. Equal weighting adds size exposure wherever it is used, even in seemingly vanilla funds.

Size And Sector Funds

When the press calls me asking, “What’s the biggest smart-beta fund?” I can’t say, “IWM” (the iShares Russell 2000 ETF (IWM | A-84)) because reporters aren’t looking for a fuddy-duddy, plain-vanilla fund.

IWM clearly accesses the size factor.

Many plain-vanilla funds carry factor tilts. Sector funds are great examples.

 

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