Deconstructing ‘Smart Beta’

August 21, 2014

 

The surprises go the other way, too—“smart funds” have some pedestrian features. If you picked VIG, the payout-tilted Vanguard Dividend Appreciation ETF (VIG | A-67) for the No. 1 slot among the smart-beta ETFs, you’d be in for a surprise. VIG, the smartest-seeming of the top 10 above, is cap weighted.

The definitions of smart beta that you have seen are working backward. They start with a set of funds that someone wants to call “smart,” and tease out their characteristics, like nonmarket-cap weighting and factor exposure. Then they generalize. That’s where the trouble begins.

Taking A Wrecking Ball To Smart Beta
The ETF menagerie is so full of complex strategies that generalizing gets you in trouble, the kind of trouble that leads you to misunderstand strategies and to miss investment opportunities. I’ve turned the ETF universe inside out and upside down, but I can’t find a definition for “smart beta” that makes sense of the jumble of U.S.-listed ETFs. Instead, I propose we address the illogic of existing smart-beta definitions, and then pursue my radical suggestion that we ditch marketing labels and talk about what funds actually do.

A Common Definition?
First, we need to establish the ground rules. Like any type of ETF classification, a successful definition of smart-beta ETFs must satisfy basic ground rules. It must:

  1. Apply to all funds consistently
  2. Classify funds according to how they are constructed, rather than by their names or marketing
  3. Make meaningful groupings
  4. Produce results that are widely acceptable to the ETF community

These ground rules will allow us to test smart-beta definitions. Any criterion that can satisfy all four ground rules is a winner—a bona fide working definition of smart beta. Conversely, if a criterion fails any of them, it’s not workable.

I am not alone in my pursuit of defining smart beta. Fund sponsors, consultants, journalists and marketers have staked out plenty of criteria they claim define smart beta. The literature converges on the following seven smart-beta criteria:

  • Transparency
  • Rules-based/quantitative
  • Thematic/specific segments or objectives
  • Noncap-weighting
  • Captures risk premia/factor exposure
  • Superior risk-adjusted returns
  • Improves portfolio diversification

100% Is Not A Meaningful Group
Those first three criteria—“transparency,” “rules-based” and “themes”—will all fail because they break ground rule No. 3. That rule, again, is that a successful definition of smart beta ETFs must “make for meaningful groupings.” These rules produce groups that contain all—or nearly all—U.S.-listed ETFs.

 

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