Why Many Smart Beta Backtests Fail

June 05, 2017

The September 2015 announcement that John Hancock and Dimensional Fund Advisors were teaming up to launch ETFs set the ETF world on fire. John Hancock seemed a natural fit for the ETF market, with a massive distribution capability and a strong track record in the mutual fund business. But Dimensional was a shock: It is famous for distributing its funds only to advisors who work with Dimensional, who have undergone extensive training and education with Dimensional. What would opening up those strategies to the masses through ETFs do?

Lukas Smart, Dimensional’s senior portfolio manager, will tackle that question and more as a headline speaker at the forthcoming Inside Smart Beta conference, taking place June 8-9 in New York City. In the run-up to that conference, Inside ETFs CEO Matt Hougan sat down with Smart to talk about why Dimensional entered the ETF space and how investors should think about its funds.

Matt Hougan: The John Hancock/Dimensional deal rocked the ETF world. Why did it make sense for Dimensional?

Lukas Smart: The basic conceptual hurdle that Dimensional had to overcome prior to entering the ETF space was whether our way of managing portfolios would work in an ETF. We have a long history at Dimensional of using an index-like approach that’s active and systematic, and we wanted to ensure that would work in an ETF framework. After some work, we found that we could in fact implement our approach that focuses on the dimensions of expected returns—or what other people may call “factors”—in ETFs.

Hougan: What was your concern?

Smart: Our history involves adding value through very careful implementation. So the question was, does the ETF framework—and particularly, a fully replicated ETF framework—support that level of care? We answered that question through a very careful construction of the index.

Hougan: Why would the ETF bring more concern than a mutual fund?
Smart: The key difference is that the ETF framework has a greater sensitivity to tracking error. In our traditional mutual funds, we don’t have a tracking error constraint, so we can be more flexible in implementation. That means a portfolio manager in our mutual funds has some discretion, and can determine if a particular trade has a benefit that outweighs the cost of implementation.

In the ETF space, you don’t have that discretion at the portfolio level, so you have to put rules into the index to accommodate that. Our index committee spent a lot of time putting in rules around things like Index MemoryTM and enhanced redistributions.

Hougan: I’ve never heard of “Index Memory” or “enhanced distribution.” What do you mean by that?

Smart: You could summarize Index Memory by saying you don’t spend a buck to make 50 cents. It takes into consideration the position of the entire index and considers if a particular change makes sense. So, for instance, we put in place concepts like “hold ranges.” Our large-cap index cuts off at 750 names, but if we have a company that bounces around from name 750 to name 800, we don’t want to constantly trade it in and out of the portfolio; that has a real cost.

We have similar rules around things like momentum, small changes in weight, etc. If a change won’t have a meaningful impact on the portfolio, it’s critical that we avoid the cost of doing it, and we had to design rules to accommodate that.


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