Finding The Right ‘Smart Beta’ ETF

January 28, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by John Eckstein, chief investment officer and director of research at Astor Investment Management. For the latest smart beta news and analysis, visit out smart beta ETFs channel.

"Smart beta" is as hot as it is poorly defined. It seems everyone wants to squeeze a bit more return out of their portfolio by switching to a different core equity holding. 

And why not? Smart beta promises the safety of an index along with the return boost of a systematic trading strategy. This article is the first of three to look at the record of some of the larger and more important smart-beta strategies currently on offer. In this part one, I examine how smart beta ETFs test their indexes before going live and examine the results of the indexes behind dividend focused ETFs. Future articles will examine other regions of the smart beta terrain.  

I'm going to define smart beta by taking both words seriously. 

I take "beta" to mean that the strategy has to be a modification of some major index. And in fact, that is the proposition on offer: Sell some of your S&P 500 Index and buy something else to replace it. The "smart" means abandoning the cap-weighted standard and finding some other sort of way to weigh constituents. A smart way, ideally.

This gives us some clarity, but leaves an interesting collection of what ETF.com classifies as alpha-seeking strategies on the sideline for now. These funds do have a mechanical trading rule, but they are too far from a baseline index to qualify under my definition. 

These funds are only about 10 percent of the size of the funds I classify as smart beta, but they could be important source of noncorrelated returns. So, we'll return in to these in a future article.

We can divide the smart-beta funds that remain first into dividend-focused funds and the rest. The dividend-focused funds have by far been the most successful, with about 75 percent of the $100 billion in smart-beta ETF assets invested in large-cap smart-beta funds managing more than $300 million, according to the latest data from ETF.com. 

Watch Your Back(test)

Before we can finally take a look at the performance of some of these funds, we must stop to consider the track record. 

Smart-beta funds select a set of rules to do their investing. They will define in advance the universe of stocks to be considered and how that large list will be narrowed down, and how the weights will ultimately be determined. 

With a strict mathematical rule, the strategies can be simulated in the past before the fund launched or before the index rules were chosen. We call these simulations "backtests." If there is an iron rule of backtests, it's that every one that sees the light of day looks good—in simulation, at least. The live indexes of the typical large dividend-focused smart-beta funds go back to about 2006, while the indexes have been simulated back to about 2001. 

If you divide each index's history into before and after its rules were published, on average, the alpha—that is, the pure return of the strategy—decreases. Meanwhile, its beta—the return that is attributable to the stock market—increases. I interpret this as evidence suggesting that a long history of real-time operation is a point in a strategy's favor. 

 

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