Smart Beta 3: Sinking Noncap Weighting

April 16, 2014

If you thought smart beta means not cap-weighted, think again.

This blog is the third installment of a series transforming our ideas about smart beta. Part I set the stage, arguing that defining smart beta in an ETF context is essentially impossible. Part 2 defined the ground rules for the analysis.

So you think smart beta is anything that’s not cap-weighted? You’re hardly alone. “Anything but cap-weighted” is the simplest definition of smart beta. But it falls apart if you rigorously use it to sort ETFs.

As a preview, consider the SPDR Dow Jones Industrial Average Trust (DIA | A-71). This is a price-weighted fund. It’s not cap-weighted, but I can’t imagine anyone would think DIA is a smart-beta fund.

And so it goes, as you’ll see as I cart out a number of examples in this blog, the third in a series that lays bare the impossibility of defining smart beta. Part I explored the problem broadly, while Part 2 introduced the tools for testing smart-beta definitions.

In any case, many funds, such as the PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-88), the Guggenheim S&P 500 Equal Weight ETF (RSP | A-75) and the iShares Select Dividend ETF (DVY | A-68), stake their smartness on their fundamental-, equal- and dividend-weighting schemes, respectively.

True, none of these funds, which seem to be legitimate smart-beta strategies, is cap-weighted. It’s so tempting to think that alternative weighting defines smart beta. And so wrong.

ETF.com tags funds by their weighting schemes in our ETF Classification System, which we call “ECS.” (Expand the “More Filters” section for full effect.) Notice two critical fields: “Selection” and “Weighting.”

Selection explains the process by which indexers choose which securities to include. Weighting shows how the indexer allocates dollars to each chosen security. These two fields describe the ways an index veers away from broad representation of its universe.

What Does ‘Cap-Weighted’ Mean?

It’s not clear what the phrase noncap-weighted means in a smart-beta context. Try it out in ECS—again, our ETF Classification System, by sorting all U.S.-listed ETFs according to their weighting scheme. You’ll find that some cap-weighted funds seem pretty smart, while plenty of noncap-weighted funds look remarkably simple.

As of April 9, 2014, a total of 912 of the 1,573 U.S.-listed ETFs, or 58 percent of them, are cap-weighted.

I mentioned the cap-weighted Vanguard Dividend Appreciation ETF (VIG | A-67) in the introduction to this series, but I didn’t show how, by selection alone, VIG builds a portfolio that is very different from the U.S. total market.

VIG restricts its portfolio to U.S. companies that have 10 or more years of annual dividend increases. VIG’s 145 constituent portfolio is smaller-cap than the U.S. total market, with lower price-earnings multiples (P/E ratios) and higher yields.

Indeed, many folks think VIG is a smart-beta fund, despite its cap-weighting.

I suspect that, when we talk about cap-weighting, we’re not talking about funds like VIG. To get to what we want, we need to get a little smarter about how we sort funds. I suggest we look for what we at ETF.com call “plain vanilla” funds.

 

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