Deconstructing ‘Smart Beta’

August 21, 2014


Of the 17 funds in the sample, all but six are more concentrated than the MSCI USA Large Cap benchmark. The equal-weighted funds are the most diversified, while the dividend funds are surprisingly concentrated.

The PowerShares S&P High Dividend Portfolio (SPHD | A-39), in particular, has serious single-security risk, with allocations of more than 3 percent to at least three different holdings as of April 30, 2014. With this level of concentration, there’s no good evidence that smart-beta funds increase diversification. Put another way, if you required better-than-benchmark diversification as a criterion for sorting smart-beta funds, you would get a quite-restricted list of smart-beta funds—one that cuts out almost all the dividend funds.

Smart-beta criterion No. 7 has fallen, along with its six compatriots. They all failed either because they didn’t make meaningful groupings, or because they made groups that are too controversial to gain acceptance in the ETF community.

Below is a recap of the seven smart-beta definitions and their shortcomings.

  1. Transparency—too broad, fails to make meaningful groups
  2. Rules based/quantitative—too broad, fails to make meaningful groups
  3. Thematic/specific segments or objectives—too broad, fails to make meaningful groups
  4. Noncap weighting—results are unacceptable to the ETF community, because too many oddball funds are included
  5. Captures risk premia/factor exposure—results are unacceptable to the ETF community because factor exposure appears in too many funds
  6. Superior risk-adjusted returns—results are unacceptable to the ETF community because only a tiny fraction of designer funds produce statistically significant excess returns
  7. Improves portfolio diversification—results are unacceptable to the ETF community because many designer funds are highly concentrated

Solving The Problem
Here’s my oh-so-radical solution: Let’s leave behind marketing labels and talk about what funds actually do.

Instead of talking about smart beta, with all the baggage of errant factor exposure and missing excess risk-adjusted returns, let’s talk about the exposures the fund targets, and the process by which they get there. Let dividend funds be dividend funds; let value be value; let momentum be momentum; and low volatility be low volatility.

Let’s talk instead about a fund’s strategy.

Vanilla is a strategy. So are equal weighting, fundamental analysis, duration hedging and commodity futures optimization. Even price weighting is a strategy, albeit an antiquated one.

Strategy gets at the heart of how a fund is built, because we base it on index construction methodology. Strategy cuts away the marketing hype and describes what a fund or an index actually does. has developed a strategy tag for every U.S.-listed equity, fixed-income, commodity and currency ETF, including levered and inverse funds. Strategy assignments are completely rules-based, in keeping with our ETF classification methodology. Want to count the dividend-focused funds, or the buy-writes, momentum-seekers or plain-vanilla funds? No problem.

You can find our list of strategies and their definitions in the appendix of this article.

Which Strategy Is Smart For You?
Once we stop fighting about what’s “smart” and what’s “dumb” and stop looking for risk-adjusted excess returns, we can get down to the business of finding the strategy we want.


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