Smart Beta 7: ETFs From The Inside Out

May 27, 2014

Q&A

I bet you have some questions. So did my colleagues. So I'll end this blog with a FAQ section.

Q: Why do you call equal weighting "idiosyncratic," and not "strategic"? Don't all studies of alternative indexing reference equal weighting?

A: Equal weighting is an agnostic position, implying/applying no informational advantage. We're looking for actual security analysis to inform index construction. If there's anything "smart" about our strategic funds, it's the grounding in research.

Also, in practice, more often than not, equal weighting is an adaptation—a way to get around RIC compliance rules. It's a classic adaptation.

Q: Why include macroeconomic factors in the strategic group? They have nothing to do with security valuation.

A: Macroeconomic factors, such as GDP growth or fiscal policy, are well-researched determinants of security returns. While differing from bottom-up factors in the level of specificity, top-down factors can swamp security-specific valuations during periods of political or economic uncertainty.

Q: Why do you consider value and growth to be part of the strategic group? These are well-established style-box funds, not part of the growing "smart indexing" trend.

A: Value and growth are classic, mostly bottom-up security valuation techniques. The most common value and growth metrics—such as internal growth rates, price/book ratios, price/sales ratios, dividend yields and sales growth trends—often serve as inputs in fundamental indexation. (Some growth funds also include momentum or technical indicators.)

In truth, it's sometimes hard to know where value ends and fundamental or dividends begin. There's a case for lumping them all together in "bottom up," but it wouldn't help investors who actually want to find dividend funds.

Q: What about the small-caps? In blog 1 of this series, you walloped us with the proposition that the iShares Russell 2000 (IWM | A-83) accessed the small-cap factor. Shouldn't the strategic funds include the small-caps and other factor funds?

A: In a sense, every fund that's not a total-market fund like the Vanguard Total World Stock fund (VT | B) is slicing, dicing and applying some sort of selection criteria. There's a case to be made that 99 percent of all funds are strategic. But that's not a useful distinction.

ETF.com's strategic group is meant to isolate funds by construction methodology, not by exposure. Market-cap-selected and -weighted small-cap funds are, by definition, vanilla, because they select and weight constituents based on market cap. If they don't, they're not vanilla; they're a strategic small-cap like the Schwab Fundamental US Small Cap ETF (FNDA | B-84).

Q: Don't the copycat funds select securities from active managers using well-researched techniques?

A: Maybe, but there's no way to know for sure. Who knows what those active managers are up to?

Q: Can committee-selected funds be counted in the strategic group?

A: No, because they're not fully rules-based. These funds do have a strategy assigned to them, but we won't count them in response to any "smart beta" requests or as part of the strategic group. At present, there are only 12 funds that suffer this fate, mostly Rogers Commodity funds. Who could replicate Jimmy Rogers?

Note that committee-selected funds can count as vanilla, so long as the committee doesn't alter the overall representativeness of the index (see the S&P 500 as the best-known example). We admit this is fuzzy territory, and we'll dig in hard on any new committee-based funds we see. Luckily, we don't see much development here.


At the time of publication, the author held long positions in EFA and IWM. Contact Elisabeth Kashner, CFA, at [email protected].

 

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