Smart Beta 7: ETFs From The Inside Out

May 27, 2014

Adaptive Vs. Adoptive

Some indexes are essentially adaptive—they're solving a problem of a particular place, time or social group. Others are adoptive, applying research and economic thinking to value and analyze securities.

The adaptive funds, which I'm calling idiosyncratic, feature either an arbitrary weighting scheme or restricted universes. Neither their selection nor their weighting have to do with their components' economic properties. Some have adapted to harsh conditions including illiquidity, competition among exchanges, inaccessible primary markets and, according to some, evil corporations.

Others idiosyncratics evolved in primitive environments, including the unmeasured market of the 19th century and today's over-the-counter bond market. The equal-weighted funds, adaptations to SEC requirements—or sometimes touted as an antidote to price-bubbles in cap-weighted indexes—fail to use their resources well. They incorporate no information about their component securities.

 Idiosyncratic Funds

In contrast stand the adoptive funds. These funds have their origins not in the wilderness, but in a land of abundance. These indexes are essentially rearranging a vanilla universe according to a theory about what drives returns. They're looking to thrive, not just survive. They seek out and emphasize specific economic properties in their selection universes.

The adoptive funds make up my strategic category. They're my second-best answer to trend-watchers who want to count "smart-beta" funds.

The main categories of strategic funds are bottom-up; technical; and macroeconomic. Bottom-up indexes use income statements and balance-sheet data. Technical or quantitative indexes incorporate patterns of security prices. Macroeconomic index construction involves assessments of the prospects of entire sectors, countries and political systems.

When issuers or the press call, we'll provide this list of strategic fund types:


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