Smart Beta 3: Sinking Noncap Weighting

April 16, 2014

Hedged Exposure In The 51 Percent

There are two problems with looking for smart beta by flavor (vanilla versus everything else). There are some pretty exotic funds in the vanilla group, while some plain-Jane ETFs make it to the not-vanilla bunch.

Let’s start with the easier of the two problems, the one type of by-the-book plain-vanilla fund that seems smart.

The ProShares’ High Yield - Interest Rate Hedged ETF (HYHG | C) is cap-weighted and selected, but has an overlay that grossly alters its pattern of returns. HYHG shorts U.S. Treasury futures to manage interest-rate risk.

So, HYHG’s returns will be different from the overall high-yield market any time interest rates move. Hedging exposures is a clever, complex strategy, but HYHG’s cap weighting and selections leaves it stuck in the vanilla bucket.

Really, though, this isn’t the end of the world. I’m sure that if the hedged funds were the only problem with using alternative weighting as a smart-beta definition, we would deal with it as a minor exception.

But the mishmash of strategies in the alternatively weighted group—the 49 percent—is the bigger challenge. Let’s walk through the remaining test cases and I’ll show you why anything-but-cap-weighting fails as a smart-beta definition.

Flotsam In The 49 Percent

There’s a group of legacy funds in the 49 percent. These funds solve the problems of yesteryear, but live on in the ETF landscape. Our test cases Nos. 2 through 4 show all too well how some not-exactly-smart funds live alongside the hot new factor funds in the alternatively weighted bucket.

Idiosyncratic funds like the Nasdaq 100 ETF—the PowerShares QQQ (QQQ | A-52)—and the SPDR Dow Jones Industrial Average Trust (DIA | A-71) are not plain vanilla, so they land in the 49 percent.

The $46 billion QQQ restricts its selection universe to the Nasdaq. QQQ has its oddities—it excludes financials, limits the weight of top holdings, rebalances unpredictably and sandwiches an equally weighted tier between two cap-weighted ones.

In other words, QQQ tries to be smart, but not in the way you might think.

Nasdaq, advancing its status as an exchange, chose the index’s caps and the redistribution scheme to adapt to high concentrations in its listings like Microsoft or Apple. Although modern indexing’s breadth makes QQQ look ridiculous, the problem of concentration is still real. Bottom line: QQQ ain’t smart beta.

Also in the 49 percent is DIA, which tracks the Dow Jones industrial average, the granddaddy of all indexes. No question, measuring the stock market was a huge innovation in the 19th century, but the Dow hasn’t aged well.

The Dow is selected by a committee and holds one share (split-adjusted) of each of its 30 constituents. Today it’s clear that the Dow is about as dumb an index as could be. Nobody wants to put DIA on a smart-beta list.

The 49 percent has other legacy funds too, some from much more recent vintages. Launched in 2002, when access to emerging markets was difficult and the iShares MSCI Emerging Markets ETF (EEM | B-100) was highly optimized, the BLDRS Emerging Markets 50 ADR (ADRE | B-35) large-cap and ADR-only construction created a tradable and hedge-able basket.

ADRE clocks in at 93 percent large-caps, and overweights Brazil, telecoms and energy. ADRE is not vanilla, but it’s not smart beta, either.

 

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