Deconstructing ‘Smart Beta’

August 21, 2014

 

In particular, three groups of funds that have factor exposure but don’t seem like smart beta will prove that factor exposure doesn’t work as a smart-beta criterion:

  1. Plain-vanilla size and sector funds often have small-cap or value exposure.
  2. Cap-weighted value funds deliberately access the value premium.
  3. Equal weighting adds size exposure wherever it is used, even in seemingly vanilla funds.

Size And Sector Funds
When the press calls me asking, “What’s the biggest smart-beta fund?” I can’t say, “IWM” (the iShares Russell 2000 ETF (IWM | A-84)), because reporters aren’t looking for a fuddy-duddy, plain-vanilla fund. Yet IWM deliberately accesses the size factor.

As a matter of fact, many plain-vanilla funds carry factor tilts. Sector funds are great examples.

The Utilities Select Sector SPDR Fund’s (XLU | A-94) weighted average market cap of $25 billion (as of April 1, 2014) is one-fifth that of its parent S&P 500 Index of $118 billion. Meanwhile, SSgA’s Energy Select Sector SPDR (XLE | A-96) is more of a value play than the world’s biggest value ETF. XLE’s P/E ratio was 16.7 as of April 1, 2014, versus 17.11 for the iShares Russell 1000 Value ETF (IWD | A-86).

Does anyone think IWM, XLU and XLE are “smart beta” funds?

Until folks cast aside the “anything but cap weighting” definition of smart beta, using factor exposure to define smart beta will create surprising, unacceptable groupings.

XLU’s and XLE’s size or value tilts are knock-on effects, reflective of their sectors. By contrast, FirstTrust and PowerShares have deliberately crafted sector suites, with products like the First Trust Energy AlphaDex (FXN | B-56), which is designed to capture the value and growth factors, in which the tiered-weighting scheme introduces a distinct small-cap tilt. That still doesn’t lessen XLU and XLE’s factor exposure.

Growth And Value Funds
The cap-weighted Russell 1000 Value Index and its counterparts from S&P, MSCI, CRSP and FTSE challenge the conflation of smart beta and factor exposure.

Because these indexes are cap-weighted (sometimes with complex buffering and treatment-of-borderline-security rules), they might not seem like smart beta, especially in contrast to a value-weighted index. But often the results are the same.

IWD and iShares’ MSCI USA Value Factor ETF (VLUE | B-86) each target the value effect, one via security selection, and the other via weighting. VLUE’s and IWD’s portfolios and returns are remarkably similar.

VLUE and IWD share a parent universe of large- and midcap U.S. stocks, represented in Figure 3 by the iShares Russell 1000 ETF (IWB | A-92) and the iShares MSCI USA ETF (EUSA | B-96). VLUE includes all stocks in the MSCI USA Index, but weights them by factors like earnings and book value per share. IWD culls the value stocks from the Russell 1000, then cap-weights them.

DeconstructingSmartBeta

 

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