Deconstructing ‘Smart Beta’

August 21, 2014


Look carefully at Figure 3. Which better captures the value premium: VLUE or IWD?

IWD beats VLUE with the lower P/B—the classic value metric. IWD also has the higher dividend yield, but VLUE sports the lower P/E ratio. Yet these are minor differences. As of April 10, 2014, VLUE’s correlation with IWD is 0.98, with a 0.99 beta. The two are largely indistinguishable, but if I had to pick a value fund, I’d go with IWD.

Security selection can produce powerful portfolio tilts, just as weighting can, because any security not in a port­folio has a weight of zero percent.

If VLUE is a factor fund, then IWD is a factor fund.

Will the ETF community accept cap-weighted growth and value funds like IWD as smart beta? Changing perceptions takes time; I’m not sure the ETF community is ready to put IWD in the same bucket as VLUE. And even if the community were ready to include all the style funds as smart beta, I think there would still be pushback about the equal-weighted industry funds.

Equal-Weighted Funds
With no vestige of cap weighting, and with deliberate index design that promotes the small-cap effect, equal-weighted funds check every smart-beta preconception box.

But some equal-weighted funds don’t seem like smart beta.

Compare SPDR S&P Retail (XRT | A-45) with Guggenheim’s S&P 500 Equal Weight ETF (RSP | A-75). RSP tops nearly everyone’s smart-beta list. XRT, meanwhile, seems like a “plain Jane” retail fund even though XRT—like RSP—is equal weighted. Guggenheim and SSgA have vastly different reasons for equal-weighting their funds, and it shows in the way they market their funds, and, in turn, in the way investors think about these funds.

Guggenheim’s claim that equal weighting improves risk efficiency helps differentiate RSP among the 66 U.S. large-cap funds. RSP’s asset base was about 1/20th the size of SPY’s as of April 2, 2014.

SSgA claims that XRT represents the U.S. retailing industry. Yet XRT tilts much smaller than the overall retail industry. As of April 1, 2014, XRT’s weighted average market cap is about 15 percent of that of all cap-weighted U.S. retailers, according to Thomson Reuters. As long as SSgA says XRT represents U.S. retailers, hardly anyone will think XRT is a smart-beta fund.

XRT and RSP are equally equal weighted. If RSP is smart beta, then XRT must also be smart beta. If XRT is not smart beta, then neither is RSP.

The Vagaries Of Factor Exposure
Factor exposure is not a reliable smart-beta indicator. Many funds have some kind of factor exposure, whether by happenstance (XLU), by design (IWM and IWD) or as a defense against the taxman (XRT). Unless the ETF community is ready to accept these old-line funds in the smart-beta rolls, factor exposure won’t work as a smart-beta criterion—neither in its pure form, nor adapted to account for deliberateness, nor expanded to include alternative weighting.

Neither the anything-but-vanilla approach nor the factor-exposure approach to defining smart beta works across the ETF universe. When you use these criteria to sort U.S. ETFs, you get all kinds of unexpected—and, for many, unwelcome—results.

Perhaps the most reliable smart-beta flag lives in the marketing material, where issuers claim, subtly or boldly, their rules-based designer strategy will outperform a plain-vanilla index on a risk-adjusted basis.

Burying Smart Beta
So far, I’ve laid to rest five of the seven definitions: transparency, rules-following and thematic exposure; alternative weighting; and factor exposure. The last two are superior risk-adjusted returns and improved diversification.

No. 7, diversification, is a mere trifle. The real heart of the matter is testing for excess risk-adjusted returns. Why else would anyone go to the trouble and expense of rearranging a plain-vanilla index?


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