Smart Beta 4: Factor Exposure's Curveball

April 22, 2014

The Utilities Select Sector SPDR Fund’s (XLU | A-94) weighted average market cap of $25 billion (as of April 1, 2014) is one-fifth that of its parent S&P 500 Index of $118 billion, and smaller than the iShares MSCI USA Size Factor (SIZE | B-79)’s $37 billion.

SSgA’s Energy Select Sector SPDR (XLE | A-96) is more of a value play than the world’s biggest value ETF. XLE’s P/E ratio was 16.7 as of April 1, 2014, versus 17.11 for the iShares Russell 1000 Value ETF (IWD | A-86).

Does anyone think IWM, XLU and XLE are smart-beta funds?

Until folks cast aside the “anything-but-cap-weighting” definition of smart beta, using factor exposure to define smart beta will create surprising, unacceptable groupings.

XLU’s and XLE’s size or value tilts are knock-on effects, reflective of their sectors. FirstTrust and PowerShares have deliberately crafted sector suites, with products like the First Trust Energy AlphaDex (FXN | B-56) that are designed to capture the value and growth factors, in which the tiered-weighting scheme introduces a distinct small-cap tilt. That doesn’t lessen XLU and XLE’s factor exposure.

Growth And Value Funds

There are highly engineered value and growth indexes that don’t seem like smart beta to many. The Russell 1000 Value and its counterparts from S&P, MSCI, CRSP and FTSE challenge the conflation of smart beta and factor exposure.

Because these indexes are cap-weighted (sometimes with complex buffering and treatment-of-borderline-security rules), they might not seem like smart beta. Look at a so-called smart value fund and a plain-vanilla one. Is one smarter than the other?

IWD and iShares’ MSCI USA Value Factor ETF (VLUE | B-86) each target the value effect, one via security selection, and the other via weighting. VLUE’s name has the magic word “factor,” and VLUE is factor-weighted, but VLUE and IWD are remarkably similar.

VLUE and IWD share a parent universe of large- and midcap U.S. stocks, represented in the table below by the iShares Russell 1000 (IWB | A-92) and the iShares MSCI USA (EUSA | B-96). VLUE includes all stocks in the MSCI USA Index, but weights them by factors like earnings and book value per share. IWD culls the value stocks from the Russell 1000, then cap-weights them.

Look carefully at the table below. Which better captures the value premium: VLUE or IWD?

Ticker Fund Weighted Average Market Cap (in billions) P/B P/E Dividend Yield Holdings Count Selection Weighting
IWB iShares Russell 1000 105 2.7 19.5 1.79% 1,019 Market Cap Market Cap
EUSA iShares MSCI USA 112 2.7 19.1 1.84% 605 Market Cap Market Cap
IWD iShares Russell 1000 Value 112 1.8 17.1 2.12% 668 Multi-Factor Market Cap
VLUE iShares MSCI USA Value Factor 114 2.1 16.6 2.00% 605 Market Cap Fundamental


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