Deconstructing ‘Smart Beta’

August 21, 2014


Current regulations require all ETFs to post their holdings daily. Until and unless the Securities and Exchange Commission permits nontransparent active ETFs, the transparency criterion includes every single U.S.-listed-ETF. Transparency is useless for parsing the ETF landscape. One hundred percent of anything is the whole shebang, not a group.

Rules-Based, Or Quantitative
This criterion distinguishes between passive and active strategies. It may be useful in the overall investment marketplace where active managers dominate, but it’s insufficient in the ETF universe. Ninety-five percent of ETFs and 99 percent of ETF assets are tied to rules-based indexes. I will exclude active funds from any discussions of smart-beta definitions.

Thematic Or Specific Exposure
The ETF market is a salad bar full of slicing and dicing. Except for 10 global, broad-based equity and commodity funds, every ETF offers a narrowed-down view of the market. Again, 99 percent of funds is not a meaningful group.

Other smart-beta criteria are a bit more complex and deserve much more in-depth examination. Noncap weighting is probably worth a research paper all on its own.

Noncap Weighting
A Broad Category
“Anything but cap-weighted” is the simplest definition of smart beta. But it falls apart if you rigorously use it to sort ETFs.

Indeed, many funds, such as the PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-88) and the iShares Select Dividend ETF (DVY | A-68), stake their “smartness” on their fundamental- and dividend-weighting schemes, respectively, and thereby imply that weighting is the key to smart beta.

It’s tempting to think that alternative weighting defines smart beta. But that’s far too simplistic, as we shall see.

The Weight Of Non-selected Securities Equals Zero
It’s not clear what the phrase “non-cap-weighted” means in a smart-beta context.

As of April 9, 2014, a total of 912 of the 1,573 U.S.-listed ETFs, or 58 percent of them, are cap weighted. But not all of the cap-weighted ETFs mimic the broad market. VIG is a perfect example.

Cap-weighted VIG builds a portfolio that is very different from the U.S. total market, by security selection alone. VIG restricts its portfolio to U.S. companies that have 10 or more years of annual dividend increases. VIG’s 145 constituent portfolio (as of April 1, 2014) is smaller-cap than the U.S. total market, with lower price-earnings multiples and higher yields. Indeed, many consider VIG to be a smart-beta fund, despite its cap-weighting. Security selection can tilt a fund’s portfolio well away from the broad market.

We need to get a little smarter about how we sort funds if we want to get to what most folks mean when they say “cap weighted.” I suggest we take a closer look at “plain vanilla” funds.


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