ETF Report: Outsmarting The Market

March 11, 2014

ETF Report digs into the wide-ranging smart-beta field, surveying the various index methodologies and what they offer investor portfolios.

[This article previously appeared in the March issue of ETF Report.]

Complain as he might, the world of indexing has gotten away from Vanguard founder John Bogle's vision.

To be sure, the glory days of the Vanguard 500 Index Fund are hardly over—it's still the world's biggest equity mutual fund. But the capitalization-weighted approach Bogle pioneered in the mid-1970s that weights securities in a portfolio based on their prices is facing real competition from new index funds.

The name of the game in this expanding pocket of index investing is to beat the returns of so-called pure-beta cap-weighted methodologies pioneered by Bogle, in ways big and small. It's not exactly an easily characterized trend. The semantic debate about just what to call these investments continues.

Whether you call it alternative beta, enhanced beta, smart beta, intelligent beta, factor-focused investment or "fundamental" indexing, it truly is a Babel of beta, courtesy of the Wall Street marketing machine.

But make no mistake: Investors now have a variety of ways of carrying out indexing, whether they want tilts toward low-volatility stocks or wish to embrace a rules-based approach to enhance returns by buying low and selling high.

In all, about $200 billion in U.S. ETF assets are earmarked to so-called smart-beta strategies, and it seems as if the asset-gathering has begun to accelerate significantly in the past year or so. A recent Cogent study found that one in four institutional "decision makers" are now using smart-beta ETFs.

Tech Bubble Roots

While academic research probing alternatives to cap-weighted indexing has been around for a while, the insurgency against cap weighting really began to take shape after the technology-stock bubble burst in 2000.

Countless tech stocks, most notably Cisco Systems, soared in 1998 and 1999, and began occupying bigger and bigger pieces of whatever cap-weighted indexes they were part of. That had major consequences after the Nasdaq peaked on March 10, 2000, and started tumbling thereafter.

Investors experienced unusually sharp losses as tech stocks fell Earthward, giving rise to the expression the “Cisco Effect” that captures the essence of what transpired for countless investors in cap-weighted index funds. Those inflated share prices were deflating, and so were those cap-weighted indexes.

Something clearly must be wrong with the “efficient market hypothesis,” which holds that asset prices are essentially on the mark because the market reflects all available information, according to pioneers of the movement, including Rob Arnott of Research Affiliates and Jonathan Steinberg of WisdomTree Investments.

“We have an investment view that markets are not efficient, and there is a mean-reversion,” said Michael Larsen, global head of Affiliate Relations at Newport Beach, Calif.-based Research Affiliates.

“There’s a lot of good information out there, but behaviorally, investors overreact or underreact to information at times,” Larsen added, arguing that that’s why securities are routinely mispriced.

“Given that inefficiency, we believe that’s a great opportunity that can be exploited for the benefit of investors in a very low-cost manner,” Larsen said, who noted that at the end of last year, about $117 billion in assets was benchmarked to Research Affiliates indexes.

Equal Weighting

iShares MSCI EAFE Small Cap ETF (SCZ)

Equal-weighted strategies are as good a place to start as any, since they're easy to understand and have been around the longest.


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