Composite funds use more than one factor in adjusting their weights.
For example, the First Trust Large Cap Core AlphaDex Fund (FEX | B-81) includes both value and growth factors, while the FlexShares Morningstar U.S. Market Factor Tilt ETF (TILT | A-87) tilts toward both small-cap and value stocks.
Equal-weight funds might be usefully considered as composite funds as well.
By far the largest fund in this group—with 40 percent of the total assets—is the Guggenheim S&P 500 Equal Weight ETF (RSP | A-84). With RSP, investors are getting a hybrid tilt to their portfolios here as well as extra exposure to the smaller companies in the S&P 500.
More surprisingly, RSP investors are getting a substantial value tilt as well, perhaps as a consequence of rebalancing away from companies whose prices have risen. I suspect that the extra exposure to value is a function of the underlying index, because when I run the same analysis on the First Trust Nasdaq-100 Equal Weighted ETF (QQEW | B-63), it shows the opposite tilt; that is, away from value stocks.
Another fund that has composite effects that are not immediately apparent is the iShares MSCI USA Size Factor ETF (SIZE | B-82). While this fund overweights the smaller stocks in its universe, it also uses volatility to set position sizes, favoring the lower-volatility stocks. The end result is that SIZE only has a modest exposure to the traditional small-cap outperformance factor, that Kenneth French of Dartmouth was instrumental in articulating.
Conclusion & Next Steps
If there’s one thing the industry can agree on, it’s the regret that the “smart beta” label was ever coined and, worse yet, has proven to be so resilient. We can't change that now. What we can do is decide if some of these “smart beta” strategies make sense in our portfolios.
For an index-based portfolio, I think several of the strategies presented here have the chance to improve a client’s outcome. But I suggest starting from the point of view of what’s missing from a portfolio and looking to find a factor exposure that can fill that gap.
An additional caveat is that all of the strategies only pick out the stocks that are the best by their metric, disregarding the aggregate. The value strategies, for example, will select the relatively most undervalued stocks, but it could be the case that the market as a whole is overvalued.
More specifically, I think careful consideration needs to be given to substituting the minimum-volatility portfolios for some amount of core equity holdings that are currently in an index. The outperformance is longstanding and widespread—though, critically, that doesn’t necessarily mean it will continue into the future.
We have one more painful mile to go in our journey, as next month I will return with an analysis of what ETF.com classifies as alpha-seeking strategies.
At the this article was written, the author’s firm owned FEX and RSP.
Astor Investment Management is a money manager with an active and economically grounded approach to asset allocation. We believe investment opportunities arise based on the ability to identify fundamental trends and changes in the economy. We build portfolios of ETFs appropriate for our analysis of the business and monetary policy cycles. For more information, see www.astorim.com; for our blog, see www.astorinsights.com.