Smart Beta 4: Factor Exposure's Curveball

April 22, 2014

IWD beats VLUE with the lower P/B—the classic value metric. IWD also has the higher dividend yield. VLUE sports the lower P/E ratio. VLUE’s correlation with IWD is 0.98, with a .99 beta. The two are largely indistinguishable, but if I had to pick a value fund, I’d go with IWD.

Security selection can produce powerful portfolio tilts, just as weighting can, because any security not in a portfolio has a weight of zero percent.

If VLUE is a factor fund, then IWD is a factor fund.

Will the ETF community accept cap-weighted growth and value funds like IWD as smart beta? Yes, I demolished alternative weighting as a smart-beta criterion in my most recent blog, but changing perceptions takes time. I’m not sure the ETF community is ready to put IWD in the same bucket as VLUE.

Even if the community were ready to include all the style funds as smart beta, I think there would still be pushback about the equal-weighted industry funds.

Equal-Weighted Funds

With no vestige of cap weighting, and with deliberate index design that promotes the small-cap effect, equal-weighted funds check every smart-beta preconception box.

Some equal-weighted funds don’t seem like smart beta.

Compare SPDR S&P Retail (XRT | A-45) with Guggenheim’s S&P 500 Equal Weight ETF (RSP | A-75). RSP tops nearly everyone’s smart-beta list. XRT, meanwhile, seems like a “plain Jane” retail fund even though XRT—like RSP—is equal-weighted.

Guggenheim and SSgA have vastly different reasons for equal weighting their funds, and it shows in the way they market their funds, and, in turn, in the way investors think about these funds.

Guggenheim’s claim that equal weighting improves risk efficiency helps differentiate RSP among the 66 U.S. large-cap funds. RSP’s asset base is about 1/20th the size of SPY’s.

SSgA claims that XRT represents the U.S. retailing industry, probably because registered investment company compliance issues drive XRT’s equal weighting. Yet XRT tilts much smaller than the overall retail industry. XRT is about 15 percent of the weighted average market cap of U.S. retailers, according to Thomson Reuters. As long as SSgA says XRT represents U.S. retailers, hardly anyone will think XRT is a smart-beta fund.

XRT and RSP are equally equal-weighted. If RSP is smart beta, then XRT must also be smart beta. I want ringside tickets to the fight this will provoke.

Factor Exposure

Factor exposure is not a reliable smart-beta indicator. Many funds have some kind of factor exposure, whether by happenstance (XLU), by design (IWM and IWD) or as a defense against the taxman (XRT). Unless the ETF community is ready to accept these old-line funds in the smart-beta rolls, factor exposure won’t work as a smart-beta criterion—neither in its pure form, nor adapted to account for deliberateness, nor expanded to include alternative weighting.

Neither the anything-but-vanilla approach nor the factor exposure approach to defining smart beta works across the ETF universe. When you use these criteria to sort U.S. ETFs, you get all kinds of unexpected—and, for many, unwelcome—results.

I’m beginning to think the most reliable smart-beta flag lives in the marketing material, where issuers claim, subtly or boldly, their rules-based designer strategy will outperform a plain-vanilla index on a risk-adjusted basis.

In the fifth part of this series, I will look at the returns of some flagship smart beta funds, to test whether smart beta funds deliver risk-adjusted outperformance.

At the time this article was written, the author held long positions in IWM and IWD. Contact Elisabeth Kashner at [email protected].


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