‘Smart Beta’ 5: No Alpha Here

May 02, 2014

Portfolio Concentration

ETF.com’s Analytics service measures portfolio concentration using the Herfindahl ratio, which is the sum of the squared weights of each constituent. The Federal Trade Commission uses the Herfindahl index to judge if mergers or acquisitions would produce monopolistic conditions within an industry.

ETF.com uses it to measure portfolio concentration, and the higher the Herfindahl ratio, the more concentrated, and the less diversified the portfolio.

Look at the Herfindahl ratios for all the popular U.S. large-cap funds (assets > $50 million) with designer strategies. I’ve ranked funds from high to low concentration.

Ticker Fund Herfindahl Ratio
SPHD PowerShares S&P 500 High Dividend 2.11%
FTCS First Trust Capital Strength 2.00%
SDOG ALPS Sector Dividend Dogs 2.00%
NOBL ProShares S&P 500 Aristocrats 1.86%
DLN WisdomTree LargeCap Dividend 1.21%
SPHB PowerShares S&P 500 High Beta 1.02%
SPLV PowerShares S&P 500 Low Volatility 1.01%
QQEW First Trust NASDAQ-100 Equal Weighted 1.00%
EPS WisdomTree Earnings 500 0.97%
RWL RevenueShares Large Cap 0.91%
SPHQ PowerShares S&P 500 High Quality 0.89%
  MSCI USA Large Cap 0.88%
FNDX Schwab Fundamental U.S. Large Company 0.72%
PRF PowerShares FTSE RAFI US 1000 0.63%
EQL ALPS Equal Weight 0.52%
FEX First Trust Large Cap Core AlphaDEX 0.33%
RSP Guggenheim S&P 500 Equal Weight 0.20%
EWRI Guggenheim Russell 1000 Equal Weight 0.12%

These complex funds are generally less diverse than the benchmark.

Of the 17 funds in the sample, all but six are more concentrated then the MSCI USA Large Cap benchmark. The equal-weighted funds are the most diversified, while the dividend funds are surprisingly concentrated.

The PowerShares S&P High Dividend Portfolio (SPHD | A-39) has serious single-security risk, with more than 3 percent to at least three different holdings as of April 30, 2014. With this level of concentration, there’s no good evidence that smart-beta funds increase diversification. Put another way, if you required better-than-benchmark diversification as a criterion for sorting smart-beta funds, you would get a quite restricted list of smart-beta funds—one that cuts out almost all the dividend funds.

And that’s it. Smart-beta criterion No. 7 has fallen, along with its six compatriots. They all failed either because they didn’t make meaningful groupings, or because they made groups that are too controversial to gain acceptance in the ETF community.

The hearse is pulling up to the funeral home, with the term “smart beta” in the back. It died from exposure to logic, and by its failure to live up to its own billing.

For closure, here’s a recap of the seven smart-beta definitions and their shortcomings.


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