The final criterion, “improves portfolio diversification,” will fail in the same way as alternative weighting, factor exposure and risk-adjusted outperformance.
To measure the extent to which adding a fund to a portfolio increases diversity, we need to know what’s in the portfolio. In the absence of a specific portfolio, the best we can do is to measure concentration within self-proclaimed “smart beta” portfolios. If these funds are less concentrated than their cap-weighted benchmarks, then this criterion will define them well. It turns out that requiring smart-beta funds to have a portfolio that is more diversified than a vanilla benchmark will create fund groups that also are not acceptable to the ETF community.
ETF.com’s Analytics tool measures portfolio concentration using the Herfindahl ratio, which is the sum of the squared weights of each constituent. The Federal Trade Commission uses the Herfindahl index to judge if mergers or acquisitions would produce monopolistic conditions within an industry.
ETF.com uses it to measure portfolio concentration. The higher the Herfindahl ratio, the more concentrated, and the less diversified the portfolio.
Look at the Herfindahl ratios for all the popular U.S. large-cap funds (assets > $50 million) with designer strategies (Figure 6). I’ve ranked funds from high to low concentration.