Deconstructing ‘Smart Beta’

August 21, 2014

 

The PowerShares Global Listed Private Equity Portfolio (PSP | F-58) faces a hard problem: delivering access to private equity returns. Private equity by definition is not publically listed, but some general partners like business development companies and MLPs are exchange-traded. The Red Rocks Global Listed Private Equity Index tracks these publically listed firms.

The index attempts to mimic what Red Rocks describes as a typical institutional private equity portfolio by differentiating between early, mid- and late-stage firms. Their weighting looks through to the listed firms’ portfolios, targeting 65 percent late-stage, 25 percent midstage and 10 percent early-stage exposure. The weight of each tier is fixed; and within the tiers, holdings are cap-weighted.

This is an inventive solution, perhaps even an advance for democracy. But I suspect it’s not the sort of indexing revolution that smart-beta believers envision.

The iShares MSCI KLD 400 Social ETF (DSI | B-90) is a cap-weighted fund that deliberately selects companies that safeguard the environment, communities, human rights and other sensitive areas. MSCI’s socially aware methodology helps some investors feel like they can align their investments with their beliefs. DSI’s portfolio isn’t vanilla, but it’s not really smart beta either.

Leave Your Cap On
The simplicity of noncap-weighting is its downfall as a smart-beta definition. Indexers have been skillful, adaptive and inventive in creating investable products that access quirky parts of the market, using a rich set of selection and weighting schemes.

These adaptations are smart, and surprisingly common in the ETF landscape. Not every alternatively weighted fund fits our presumptions of what smart beta is.

As I mentioned when I introduced the smart-beta definition ground rules, the groupings that result from definitions of smart beta have to make sense to the people who will use it. Alternatively weighted funds fail this test.

Factor exposure does no better, and for the same reasons.

Factor Investing
There is a strong movement to conflate smart beta with factor investing. For lots of folks, factor investing is the “smart” part of smart beta. Sorting ETFs by factor exposure produces groupings that could cause some rifts in the ETF community, and therefore break our ground rule regarding widespread acceptability.

Factor investing targets specific drivers of returns. The most common factors are size, value, yield, momentum, volatility and quality. These factors show up in plain-vanilla indexes, of course, but can also be targeted and amplified, especially by index providers with huge databases and crafty analysts.

The past decade has brought us factor funds like the FlexShares Morningstar’s US Market Factor Tilt ETF (TILT) and the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-45). Older “smart” funds target factors too: value in PowerShares’ FTSE RAFI US 1000 (PRF | A-88), size in Guggenheim’s S&P 500 Equal Weight (RSP | A-75) and yield in iShares’ Select Dividend (DVY | A-67).

Designer funds promote the smart-beta label. However, branding all funds with factor exposure as smart beta will start arguments. In terms of our ground rules, sorting ETFs by factor exposure produces results that are not widely acceptable to the ETF community.

If factor exposure defines smart beta, then all funds with factor exposure must be smart beta. As you will soon see, most funds have some kind of factor exposure.

 

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