MSCI Has Defined 'Smart Beta' Better

March 06, 2015

Amid all the hype surrounding “smart beta” ETFs these days, MSCI made a subtle shift in messaging and marketing not so long ago that strikes me as important.

The New York-based firm, perhaps the premier indexing shop on the planet, particularly for institutional investors, dispensed with the term “risk premia” to describe the factors that are the bread and butter of smart beta and instead chose to call them what they are: “factors.”

It was a triumph of clarity which, in some ways, is the biggest problem facing smart beta. What, at the end of the day, is mining for dividends like WisdomTree Investments does on so many of its funds, and what is the “fundamental indexing” that Research Affiliates has championed?

MSCI’s risk premia, to me, was perhaps the foggiest nomenclature of all in the smart-beta hoopla. “Risk what?” I remember asking myself—at once a bit sheepish about my ignorance but also wondering how it was that MSCI had allowed the nerds to rule the roost. But it appears the nerds are now doing what they do best in their labs, while the marketing department gets to do what it does best.

Focus On Factors

Whatever the finer points of the shift in messaging, I applaud MSCI for framing smart beta as a focus on factors. Specifically, MSCI has identified what it calls six “clear and persistent factors” over time. For the record, they are:

  • Value – MSCI Value Weighted indexes: Weight according to four fundamental variables (sales, earnings, cash flow, book value)
  • Low size – MSCI Equal Weighted indexes: Weight all stocks equally in a given parent index
  • Low volatility – MSCI Minimum Volatility indexes: Identify lowest forecast volatility stocks using minimum-variance optimization
  • High yield – MSCI High Dividend Yield indexes: Identify high-dividend stocks with screens for quality and potential yield traps
  • Quality – MSCI Quality indexes: Identify high-quality stocks by weighting based on debt-to-equity, return-on-equity and earnings variability
  • Momentum – MSCI Momentum indexes: Weight based on 6- and 12-month momentum scaled by volatility

Source: MSCI (Data normalized from Jan. 1, 1975 with factor tilts on MSCI World Index)

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