'Smart Beta' 6: A Better Definition

'Smart Beta' 6: A Better Definition

In a world without 'smart beta,' strategy is king.

Director of Research
Reviewed by: Elisabeth Kashner
Edited by: Elisabeth Kashner

In a world without 'smart beta,' strategy is king.


This blog is the sixth installment of a series transforming our ideas about "smart beta." Part 1 started with the proposition that defining smart beta in an ETF context is essentially impossible. Part 2 laid out the ground rules to prove the point; Part 3 sunk noncap weighting as a method to categorize smart beta; and Part 4 took a wrecking ball to the notion that factor-focused tilts were synonymous with smart beta. Part 5 examined the dearth of real risk-adjusted outperformance in the realm of smart beta.

In my last blog, after I demolished your hopes of defining "smart beta," I promised constructive suggestions for how best to describe complex index strategies.

So, here's my oh-so-radical solution: Let's leave behind marketing labels and talk about what funds actually do.

Instead of talking about "smart beta," with all the baggage of errant factor exposure and missing excess risk-adjusted returns, let's talk about the exposures the fund targets, and the process by which it gets there. Let dividend funds be dividend funds; let value be value; let momentum be momentum; and low volatility be low volatility.

Let's talk instead about a fund's strategy.

ETF.com's ETF Finder tool has three fields to help you understand a fund's geographic footprint, and three more that drill down into its market segment. But up to now, we haven't been very clear about investment strategy.

We've always had the fields I discussed in Blog 3—selection and weighting—that describe the process by which an index narrows and reweights its investment universe. But it's awkward to use these as filters.

Issuers sometimes add to the confusion with misleading fund names. The wildly popular WisdomTree Japan Hedged Equity Fund (DXJ | B-55) hides its dividend-paying exporter focus behind a vanilla-sounding name. Would you ever guess that the Vident International Equity ETF (VIDI | D-51) weights securities within each country by balancing expected tail-loss metrics and then weights each country according to macroeconomic factors, price/earnings ratios, momentum, and fundamental metrics?

ETF investors deserve better.

So today I'm introducing a new field: "strategy."

Vanilla is a strategy. So are equal weighting, fundamental analysis, duration hedging and commodity futures optimization. Even price weighting is a strategy, albeit an antiquated one.

Strategy gets at the heart of how a fund is built, because we base it on index construction methodology. Strategy cuts away the marketing hype and describes what a fund or an index actually does.

ETF.com has developed a strategy tag for every U.S.-listed equity, fixed-income, commodity and currency ETF, including levered and inverse funds. Want to count the dividend-focused funds, or the buy-writes, momentum-seekers or plain-vanilla funds? No problem.

Here's a list of the 27 strategies we've identified.

ActiveDuration HedgedMomentum
Bullet MaturityEnvironmental, Social & Governance (ESG)Multifactor
Buy-writeEqual-weightedOptimized commodity
Currency-Hedged DividendsFundamentalTarget Duration
Currency-Hedged FundamentalGrowthTime Since Launch
Currency-Hedged VanillaHigh BetaValue
Depositary ReceiptsLadderedVanilla
DividendsLow VolatilityVolatility Hedged


You can find strategy definitions at the end of this blog.

Strategy assignments are completely rules-based, in keeping with our ETF classification methodology. Write to me at [email protected] if you'd like a copy of the strategy rulebook or a download of each fund's strategy assignment.


Which Strategy Is Smart For You?

Once we stop fighting about what's "smart" and what's "dumb" and stop looking for risk-adjusted excess returns, we can get down to the business of finding the strategy we want.

Think about dividend funds. There are lots of great reasons to seek dividend-paying securities. Retirees like the cash flows, as do yield-seekers weary of the bond market. I reckon it will be useful to see all the dividend funds in a single list. Here are all the dividend funds that select from a U.S. total market universe:

FVDFirst Trust Value Line Dividend
HDViShares High Dividend
DVYiShares Select Dividend
PFMPowerShares Dividend Achievers
PEYPowerShares High Yield Equity Dividend Achievers
SDYSPDR S&P Dividend
VIGVanguard Dividend Appreciation
VYMVanguard High Dividend Yield
DHSWisdomTree Equity Income
DTDWisdomTree Total Dividend


Not on this list: Schwab's US Dividend Equity ETF (SCHD | A-86). SCHD's underlying index, the Dow Jones U.S. Dividend 100 Index, is more complicated than you might think. It looks for high yields, a history of dividend payment and, critically, "strong relative strength based on select financial ratios."

Financial ratios are the stuff of fundamental analysis; their inclusion in the DJ US Dividend 100 index methodology catapults SCHD out of the dividend strategy group and into fundamentals.

Also not on this list: FlexShares' Quality Dividend Fund (QDF | B-76). QDF belongs not in dividends or fundamentals, but in multifactor, because its index optimizes for management efficiency, profitability, cash flow, dividend yield and beta, with sector, industry, region and style factor constraints.

Compare SCHD and QDF's year-to-date returns with ETF.com's dividend funds that select from the total U.S. market. With the exception of cap-weighted VIG, all the dividend funds outperformed SCHD and QDF this year-to-date.

VIGVanguard Dividend Appreciation1.40%Dividends
SCHDSchwab US Dividend Equity2.85%Fundamental
QDFFlexShares Quality Dividend2.95%Multi-factor
PFMPowerShares Dividend Achievers3.21%Dividends
SDYSPDR S&P Dividend3.33%Dividends
VYMVanguard High Dividend Yield3.63%Dividends
DTDWisdomTree Total Dividend3.83%Dividends
DVYiShares Select Dividend4.62%Dividends
FVDFirst Trust Value Line Dividend4.67%Dividends
PEYPowerShares High Yield Equity Dividend Achievers4.69%Dividends
HDViShares High Dividend5.19%Dividends
DHSWisdomTree Equity Income5.50%Dividends

As of 5-16-2014

If you think dividend funds will continue to outperform other fundamental or technical factors, or if income is your top priority, you'll want to load up on plain old dividend funds. If you prefer to spread out your bets, a fundamental or multifactor fund like SCHD or QDF could be perfect for your portfolio. It's all about what's smart for you.

Labeling and talking about funds by strategy allows us to hone in on the funds we want. It's much more sophisticated and useful than lumping funds into an ill-defined "smart beta" group, and much more reliable than hoping for guidance from a fund's name.


Comparing Strategies

ETF.com's strategy label lets us compare strategy results across sectors, countries or time periods. We can dig into a segment and describe its competitive landscape. And we can understand its performance under a variety of market conditions. If a strategy happens to produce significant risk-adjusted alpha, we can talk about why, or why some implementations of the strategy might be working better than others.

Take the U.S. large- and midcap low-volatility funds, for example.

As of May 12, 2014, the oddly named iShares MSCI USA Size Factor ETF (SIZE | B-78), which weights its 600-plus large- and midcap securities to favor low volatility, returned 16.85 percent over the past year. That compares with an 11.07 percent return for the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-49), which both selects and weights its constituents by low volatility. The SPDR Russell 1000 Low Volatility ETF (LGLV | B-66), which uses an optimizer to select and weight for low volatility, while reducing momentum, beta and turnover, split the difference of the other two ETFs, with returns of 14.77 percent.

Meanwhile, the SPDR S&P 500 ETF (SPY | A-97) bested them all, with a return of 18.40 percent. For the past year, the less-intensely low volatility, the better. Interesting, right?

The buy-write ETFs also tell an interesting tale. Two ETFs write calls on the S&P 500: the PowerShares S&P 500 BuyWrite Portfolio (PBP | C-59) and the Horizons S&P 500 Covered Call (HSPX | C-82). PBP writes at-the-money calls on the S&P index, trading premium income for each month's potential S&P 500 appreciation. HSPX writes out-of-the-money calls on single stocks, earning less premium income than PBP, but preserving more of the S&P 500 Index's potential upside.

In 2014's sideways equity markets, selling premium has paid off. PBP's year-to-date 4.01 percent return is nearly twice HSPX's 2.15 percent or the S&P 500's 2.40 percent, as of May 16, 2014. If we get a sudden rally, the situation should reverse.

Strategy matters. Smart investors should focus on fund construction, not on marketing claims. My new strategy label is a great starting place.

We've observed a decent mourning period for the term "smart beta." Now we are free.

Free to read index methodology documents, free to draw connections between fund construction and performance, free to find strategies that work for us.

How will you find ETF.com's strategy designation?

I'm sorry to say, it might be a while before we can add strategy to the Finder, because our development queue is jammed full with exciting projects. Until we have the bandwidth to add strategy to the Finder, we'll happily send you a strategy assignment spreadsheet covering all U.S.-listed ETFs (except for asset allocation and alternatives) anytime you need one. Email me at [email protected] to request one.


An Ending Without An End

Did you notice that I've closed out my promised final "smart beta" blog without answering the question "how many 'smart beta' funds are there?"

By now it should be obvious that my best answer is "none, because 'smart beta' is dead, but I'll be delighted to help you think about a fund's strategy."

Still, some folks will demand statistics, and won't take "zero" or "dead" for an answer.

So expect a seventh blog, explaining how I will use our strategy designation to help folks think about the ETF landscape. In the meantime, think about which of the 27 strategies listed below would make your personal "smart beta" list. No credit unless you can defend your choices using a consistent rule set. "I know it when I see it" doesn't count.

ActiveHumans pick and allocate the constituent securities.
Bullet MaturitySelects bonds that mature within a specified, narrow date range.
Buy-writeWrites call options on securities held.
CopycatSelects securities held in selected actively managed portfolios.
Currency Hedged DividendsHedges out the currency risk of a portfolio that uses a firm's dividend payments to select and/or weight securities.
Currency Hedged FundamentalHedges out the currency risk of an index that uses financial statement information to select and/or weight securities.
Currency Hedged VanillaHedges out the currency risk of a vanilla index.
Depositary ReceiptsSelects only securities listed as depositary receipts.
DividendsUses a firm's dividend payments, measured in dollars or yield percent, to select and/or weight securities.
Duration HedgedUses interest-rate derivatives to alter a fixed-income index's interest-rate sensitivity.
EqualThe index invests one dollar in each security, regardless of price or market cap. Large-caps are underweighted and small- caps overweighted relative to a vanilla index.
ESGSelects and sometimes weights securities based on the issuing company's actions and policies on various environmental, social or governance issues.
Exchange-specificSelects only securities listed on a particular stock exchange, such as the NYSE or Nasdaq
FundamentalUses financial statement information such as price/book, return on assets or dividend yield to select and/or weight securities
GrowthSelects securities with above-average price or earnings growth potential.
High BetaSelects and/or weights securities targeting a more volatile than average portfolio.
LadderedSelects securities with staggered maturities.
Low VolatilitySelects and/or weights securities targeting a less volatile than average portfolio.
MomentumSelects securities based on a history of price trends.
MultifactorUses a combination of fundamental, technical and macroeconomic inputs to select and/or weight securities.
Optimized commoditySelects futures contracts' tenors in order to miminize or mitigate the effects of contango.
Price-weightedThe index holds one share of each security, regardless of price. Daily returns are most strongly influenced by the highest-priced securities.
Target DurationSelects and/or weights fixed-income securities to maintain a specific portfolio duration.
Time Since LaunchSelects securities according to how much time has elapsed since its IPO.
ValueSelects undervalued securities based on financial ratios.
VanillaRepresents the opportunity set in its market segment.
Volatility HedgedHedges vanilla portfolios using VIX futures or options.


At the time this article was written, the author held no positions in of the funds cited. Contact Elisabeth Kashner, CFA, at [email protected].


Elisabeth Kashner is FactSet's director of ETF research. She is responsible for the methodology powering FactSet's Analytics system, providing leadership in data quality, investment analysis and ETF classification. Kashner also serves as co-head of the San Francisco chapter of Women in ETFs.