Smart Beta 3: Sinking Noncap Weighting

April 16, 2014

Plain Vanilla

Plain vanilla means that an index fully represents the long side of the opportunity set of the market it targets. Critically, plain-vanilla indexes are market-cap-oriented in two ways: selection; and weighting. We do make allowances for S&P’s committee-based selection process and for adaptations needed in the futures markets, where the net exposure is zero.

Filtering ECS—our ETF Classification System—for plain-vanilla funds gives more sensible results than just filtering by market cap. If you try it (instructions in the endnotes), you’ll find the plain-vanilla funds really do seem to be broad-based representations of an overall market.

As of April 9, 2014, 810 U.S. ETFs are plain vanilla—that’s 51 percent.

It’s the other group, the 49 percent, that will make you squirm. That 49 percent is like the parking lot crowd outside a Grateful Dead show: You can find just about anything there—the smart, the stupid, the jugglers, the clowns and the wastrels.

More formally, alternative weighting fails as a smart-beta criterion because when it’s applied to all funds according to their structure it produces groups that aren’t widely acceptable within the ETF community.

Anyone who knows the history of indexing should not be surprised by this outcome.

Stock market indexes date back to the 19th century. Today’s indexes serve myriad purposes, from offering broad access to a market, to maximizing tradability, to capturing narrow themes. Often, indexers use specialized selection and weighting processes to create investable products.

The seven test cases below show the folly of relying on selection and weighting schemes to define smart beta. I‘ll use these as examples to show you, one by one, how indexers ingeniously use selection and weighting to create investable products in challenging markets.

Their solutions are usually smart, but the indexes they build are nothing like the fundamental, dividend or low-volatility schemes you call to mind when you think of smart beta.

Funds That Text The Noncap-Weighting Aspect Of A Smart-Beta Definition

Ticker Fund Selection Weighting Problem Addressed
HYHG ProShares High Yield - Interest Rate Hedged Market Value Market Value Hedging
QQQ PowerShares QQQ NASDAQ - Listed Multi-Factor Concentration
DIA SPDR Dow Jones Industrial Average Trust Proprietary Price Measuring the market
ADRE BLDRS Emerging Markets 50 ADR Depository Receipts Market Cap Liquidity
KBE SPDR S&P Bank Market Cap Equal RIC requirements
PSP PowerShares Global Listed Private Equity Proprietary Tiered Thematic exposure
DSI iShares MSCI KLD 400 Social Principles-based Market Cap Moral issues

Every one of these funds’ indexes solves a problem: from hedging duration exposure, to maximizing tradability in an illiquid market, to providing compliant exposure to narrow industries or creating thematic exposure.

All of them are adaptive, though some have not aged well. They are all edge cases, testing the usefulness of a plain-vanilla smart-beta definition.

 

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