Smart Beta 3: Sinking Noncap Weighting

April 16, 2014

Avoiding Taxes Puts Equal Weighting In The 49 Percent

Our fifth test case, the SPDR S&P Bank ETF (KBE | A-54) tracks an equal-weighted index, as do all of the SPDR S&P U.S. industry funds. Equal weighting sure seems smart in RSP, but I would guess that the ETF community would be reluctant to give S&P’s industry suite a smart-beta label. Let’s see why.

Internal Revenue Service rules for registered investment companies require diversified funds to hold no more than 25 percent in any single security and no more than 50 percent cumulatively in positions above 5 percent. In narrow industries like banking, this matters.

As of April 1, 2014, the top five U.S. banks comprised 71 percent of the industry, according to Thomson Reuters. No. 1, Wells Fargo, clocks in at 19.4 percent, while No. 5, U.S. Bancorp, takes up 6.4 percent of the weight. No diversified fund registered under the Investment Company Act of 1940 could track a vanilla banking index.

MSCI solves this problem by capping the weight of the biggest positions; others create tiers. S&P’s equal weighting is somewhat of a drastic solution, but it’s better than double taxation. Bottom line? KBE is equal weighted, but it’s probably not smart beta.

Oddballs And Hippies In The 49 Percent

Our final two test cases show how indexers use selection and weighting to craft another world, where everyone can act like an accredited investor and where good deeds are rewarded and wrongdoers punished.

To capture specialized exposures such as private equity, social media, initial public offerings or up-and-coming Nashville, indexers turn to nonmarket-cap-related rule sets to isolate an economic theme.

The PowerShares Global Listed Private Equity Portfolio (PSP | F-58) faces a hard problem: Delivering access to private equity returns. Private equity by definition is not publically listed, but some general partners like business development companies and MLPs are exchange-traded. The Red Rocks Global Listed Private Equity Index tracks these publically listed firms.

The index attempts to mimic what Red Rocks describes as a typical institutional private equity portfolio by differentiating between early, mid- and late-stage firms. Their weighting looks through to the listed firms’ portfolios, targeting 65 percent late-stage, 25 percent mid-stage, and 10 percent early stage exposure. The weight of each tier is fixed; and within the tiers holdings are cap-weighted.

This is an inventive solution, perhaps even an advance for democracy. But, I suspect it’s not the sort of indexing revolution that smart beta envisions.

The iShares MSCI KLD 400 Social ETF (DSI | B-90) is a cap-weighted fund that deliberately selects companies that safeguard the environment, communities, human rights and other sensitive areas. MSCI’s socially aware methodology helps some investors feel like they can align their investments with their beliefs. DSI’s portfolio isn’t vanilla, but it’s not really smart beta either.


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