Deconstructing ‘Smart Beta’

August 21, 2014

 

Plain Vanilla
“Plain vanilla” means that an index fully represents the long side of the opportunity set of the market it targets. Critically, plain-vanilla indexes are market-cap-oriented in two ways: security selection; and weighting. Note: We make allowances for S&P’s committee-based selection process, which de-selects many securities, but results in index series that retain virtually all properties of the overall market, and for adaptations needed in the futures markets, where the net exposure is zero.

As of April 9, 2014, 810 U.S. ETFs were plain vanilla—that’s 51 percent.

The other 49 percent is like the parking lot crowd outside a Grateful Dead show: You can find just about anything there—the smart, the stupid, the jugglers, the clowns and the wastrels. Yes, you’ll find the smart-seeming funds you’re looking for, but you’ll find many others, too. That’s how we know alternative weighting fails as a smart-beta definition.

More formally, alternative weighting fails as a smart-beta criterion because, when it’s applied to all funds, it produces groups that aren’t widely accepted by the ETF community.

Test Cases
The seven test cases in Figure 2 show the folly of relying on selection and weighting schemes to define smart beta. I’ll use these as examples to remind you how indexers use selection and weighting to create investable products in challenging markets.

DeconstructingSmartBeta

Their solutions are usually smart, but the indexes they build are nothing like the fundamental, dividend or low-volatility schemes we call to mind when we think of smart beta.

Every one of these funds’ indexes solves a problem: from hedging duration exposure, to maximizing tradability in an illiquid market, to providing compliant exposure to narrow industries or creating thematic exposure.

All of them are adaptive, though some have not aged well. They are all edge cases, testing the usefulness of a plain-vanilla smart-beta definition.

Hedged Exposure In The 51 Percent
There are two problems with looking for smart beta by flavor (plain vanilla versus everything else). There are some pretty exotic funds in the vanilla group, while some plain-Jane ETFs make it to the not-vanilla bunch.

Let’s start with the easier of the two problems, the one type of by-the-book plain-vanilla fund that seems smart.

The ProShares’ High Yield - Interest Rate Hedged ETF (HYHG | C) is cap weighted and cap selected, but has an overlay that grossly alters its pattern of returns. HYHG shorts U.S. Treasury futures to manage interest-rate risk.

So, HYHG’s returns will be different from the overall high-yield market any time interest rates move. Hedging exposures is a clever, complex strategy, but HYHG’s cap weighting and selection process leaves it stuck in the vanilla bucket.

 

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