MSCI Has Defined 'Smart Beta' Better

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)

“Show, don’t tell,” they used to tell us journalists when I was at Bloomberg News in a call to arms about how to write clearly. These six factors from MSCI constitute a clear-as-a-bell rubric—the smart-beta world’s “show, don’t tell” moment.

It’s about time, because there’s a fair amount of marketing imprecision in the vibrant world of smart beta right now. The stakes are high, too. Last year, by some estimates, as much as half of the record $243 billion in ETF inflows focused on smart-beta strategies. You hope people truly grasp what they’re getting into.

Smart Beta Real Simple

Smart beta may have more than its share of nuance, as ETF.com’s Elisabeth Kashner made plain in a multipart blog series last year, arguing that smart beta should really be thought of as a focus on distinct strategies. But complex as it may be, smart beta is not rocket science.

Smart beta boils down to mining systematic factors.

It’s no accident that “value” appears first on MSCI’s list. Value is by far the most stable and easy-to-mine factor. For example, the indexing firm Research Affiliates headed by Rob Arnott describes its ”fundamental indexing” as a “dynamic value” screening process that sells winners and buys losers in an ongoing approach that systematically manages expected returns to enhance outcomes.

Again, it’s crucial that advisors and investors know what they’re doing besides jumping on some kind of bandwagon.

Should Lead To New ETFs

These MSCI factors constitute clear talking points for investors looking to leave on the table as little beta as possible. And where the rubber meets the road, it opens the door to rolling out all kinds of ETFs.

Those include funds that either mine single factors, such as the iShares MSCI USA Momentum Factor ETF (MTUM | A-62) or ones that drill down into one of MSCI’s mother indexes into a multi-factor screen as is the case with the SPDR MSCI Emerging Markets Quality Mix ETF (QEMM | D-84). QEMM and the other 11 SPDR ETFs in the Quality Mix family combine three factors: value, low volatility and, of course, quality.

The takeaway is this: In a world where smart beta is getting serious traction, a clear system like the one put forward by MSCI is likely to help investors think through decisions more thoroughly. There’s no substitute for homework, but it sure helps to have some good tools to do the job.

At the time this article was written, the author held no positions in the securities mentioned. Contact Olly Ludwig at [email protected] or follow him on Twitter @OllyLudwig.