Destroying Smart Beta 2: Ground Rules

April 11, 2014

Meaningless

So, to return to today’s task, those first three criteria—“transparency,” “rules-based” and “themes”—will all fail because they break ground rule No. 3. That rule, again, is that a successful definition of smart-beta ETFs must “make for meaningful groupings.”

So, those first three smart-beta criteria are just too broad. They do a great job of differentiating active management and smart beta, but they are useless within the ETF universe, because they encompass at least 95 percent of all ETFs.

They’re basically meaningless. Let me explain further:

  1. Transparency: At this point, all ETFs are required by law to post their holdings daily. Until and unless the Securities and Exchange Commission permits nontransparent active ETFs, the first criterion includes every single U.S. listed-ETF. Transparency is useless for parsing the ETF landscape. One hundred percent of anything is the whole shebang, not a group.
  2. Rules-based, or quantitative: This criterion distinguishes between passive and active strategies. It may be useful in the overall investment marketplace where active managers dominate, but it’s insufficient in the ETF universe. Ninety-five percent (by count) and 99 percent (by assets) of ETFs are rules-based. Let’s agree to exclude active funds from any discussions of smart-beta definitions, and move on.
  3. Thematic or specific exposure: The ETF market is a salad bar full of slicing and dicing. Except for 10 global, broad-based equity and commodity funds, every ETF offers a narrowed-down view of the market. Again, 99 percent of funds is not a meaningful group

I know I’m being repetitive, but these three broad criteria are of no use to us for defining smart beta in the ETF context. They’re more like descriptions of ETFs, excluding active funds.

Preview Of Coming Attractions

The final four criteria—noncap weighting; captures risk premia/factor exposure; superior risk-adjusted returns; improved portfolio diversification—are each, as I said above, complex topics worthy of their own blogs. So tune in for more on those.

Be sure to come with scuba gear, because in my next blog, on alternative weighting, we’ll take a deep dive into index history, tax law, illiquidity and inaccessible markets.

Until then, I’ll let you in on my open secret: These four criteria aren’t going to pass the ground rules test either. That will help prepare us for my main point: We really do need to think of smart beta in a smarter way.

 

Links to smart-beta definitions:

Financial Times

Cogent

Towers Watson

Vanguard

Morningstar

Russell

 


 

At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner, CFA, at [email protected].

 

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