Deconstructing ‘Smart Beta’

August 21, 2014


Really, though, this isn’t the end of the world. I’m sure that if the hedged funds were the only problem with using alternative weighting as a smart-beta definition, we would deal with it as a minor exception. But the mishmash of strategies in the alternatively weighted group—the 49 percent—is the bigger challenge.

Flotsam In The 49 Percent
There’s a group of legacy funds in the 49 percent. These funds solve the problems of yesteryear, but live on in the ETF landscape. Our test cases Nos. 2 through 4 show all too well how some not-exactly-smart funds live alongside the hot new factor funds in the alternatively weighted bucket.

Idiosyncratic funds like the Nasdaq 100 ETF—the PowerShares QQQ (QQQ | A-52)—and the SPDR Dow Jones Industrial Average Trust (DIA | A-71) are not plain vanilla, so they land in the 49 percent.

QQQ restricts its selection universe to the Nasdaq. QQQ has its oddities—it excludes financials, limits the weight of top holdings, rebalances unpredictably and sandwiches an equally weighted tier between two cap-weighted ones.

QQQ tries to be smart, but not in the way you might think. Nasdaq, advancing its status as an exchange by sponsoring an index, needed to make sure its index was investable. High concentrations in listings like Microsoft or Apple pushed Nasdaq to implement position limits and a redistribution scheme. Bottom line: QQQ ain’t smart beta.

DIA tracks the Dow Jones industrial average, the granddaddy of all indexes. There’s no question that measuring the stock market was a huge innovation in the 19th century, but the Dow hasn’t aged well.

The Dow is selected by a committee and holds one share (split-adjusted) of each of its 30 constituents. Today it’s clear that the Dow is about as dumb an index as could be. Nobody wants to put DIA on a smart-beta list.

The 49 percent has other legacy funds too, some from much more recent vintages. For example, the BLDRS Emerging Markets 50 ADR (ADRE | B-35) was launched in 2002, when access to emerging markets was difficult and the iShares MSCI Emerging Markets ETF (EEM | B-100) was highly optimized. ADRE is focused on large-caps and only includes ADRs, creating a tradable and hedge-able basket.

ADRE clocks in at 93 percent large-caps, and overweights Brazil, telecoms and energy, as of April 1, 2014. It’s not vanilla, but it’s not smart beta, either.

Tax-Penalty Avoidance Puts Equal Weighting In The 49 Percent
Our fifth test case, the SPDR S&P Bank ETF (KBE | A-54), tracks an equal-weighted index, as do all of the SPDR S&P U.S. industry funds. I would guess that the ETF community would be reluctant to give S&P’s industry suite a smart-beta label, for a number of reasons.

Internal Revenue Service rules for registered investment companies require diversified funds to hold no more than 25 percent in any single security and no more than 50 percent cumulatively in positions above 5 percent. In narrow industries like banking, this matters.

As of April 1, 2014, the top five U.S. banks comprised 71 percent of the industry, according to Thomson Reuters. No. 1, Wells Fargo, clocks in at 19.4 percent, while No. 5, U.S. Bancorp, takes up 6.4 percent of the weight. No diversified fund registered under the Investment Company Act of 1940 could track a vanilla banking index.

MSCI solves this problem by capping the weight of the biggest positions; others create tiers. S&P’s equal weighting is somewhat of a drastic solution, but it’s better than the double taxation that curses funds that fail to comply with RIC regulations. Bottom line? KBE is equal weighted, but SSgA promotes it as representing the banking industry, not as smart beta.

Oddballs And Hippies In The 49 Percent
Our final two test cases show how indexers use selection and weighting to craft another world, where everyone can act like an accredited investor and where good deeds are rewarded and wrongdoers punished.

To capture specialized exposures such as private equity, social media, initial public offerings or up-and-coming Nashville, indexers turn to nonmarket-cap-related rule sets to isolate an economic theme.


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