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.

 

The Guggenheim S&P 500 Equal Weight ETF (RSP | A-72), which has been around for almost 11 years, is composed of the 500 stocks of the S&P 500 Index, but weights them equally and rebalances quarterly.

The methodology tilts the holdings toward relatively smaller firms, giving RSP access to the "size" factor that, on the whole, means greater returns over time than in a cap-weighting approach, according to academic research.

It also means returns are likely to be bumpier along the way, and that trading costs and tax consequences associated with the quarterly rebalancing do detract from returns.

Still, RSP has easily bested the returns of its close cousin, the cap-weighted SPDR S&P 500 ETF (SPY | A-97) in the past 10 years. RSP has risen an annualized 9 percent in that time frame, while SPY is up 6.4 percent.

RSP, at the end of the day, owns more of the smaller-sized S&P 500 constituents, giving the portfolio a higher beta than the cap-weighted SPY. That more than justifies the RSP's annual expense ratio of 0.40%, or $40 for each $10,000 invested. SPY, by comparison, has an annual expense ratio of about 0.09%, or $9 for each $10,000 invested.

Fundamental Pioneers

iShares MSCI EAFE Small Cap ETF (SCZ)

Around the same time that RSP came to market, WisdomTree and Arnott's Research Affiliates were working on their own ways to overcome the "Cisco Effect."

RAFI's approach, Larsen says, has a clear aspect of behavioral economics, with a rules-based approach that arguably helps prevent investors from being their own worst enemies—"institutionalized courage," to borrow Arnott's formulation.

Specifically, both the RAFI and WisdomTree screens seek to overweight undervalued securities that have high expected returns, while also underweighting overvalued securities that have relatively depleted expected returns.

"It plays off the concept of reversion to the mean," WisdomTree's Chief Investment Strategist Luciano Siracusano said.

"It can sound complicated, but it's actually taking advantage of a very simple idea, and that is that cap-weighted indexes never rebalance back to any measure of relative value. But fundamentally weighted indexes do," he added.

"Anyone who has taken a fair look at what the returns have been over the last six or seven years after these indexes and funds have been live—including 2008, which was an important down year—the conclusion is that, on balance, these strategies have beaten the cap-weighted indexes," Siracusano noted.

To be clear, Siracusano is unabashed that fundamentally indexed funds marketed by WisdomTree should be tools to "explore the core," as he puts it.

Plenty of advisors, eager to enforce good behavior on their clients, are entirely on board with that idea.

"I buy into RAFI on a philosophical basis. I'm not sure you're going to beat the market by a ton, but for us it's going to generate some alpha and also protect us when we get into the extremes. And it does," said Nick Carver, director of investment services at Neenah, Wis.-based Legacy Private Trust Co.

Legacy Private Trust manages about $800 million in assets, half of it ETFs.

Among other securities, it uses the PowerShares FTSE RAFI US 1000 ETF (PRF | A-86). PRF has what Research Affiliates calls a "dynamic value" tilt that toggles exposure over time between "core," "value" and "deep value" swaths of the U.S. large-cap equities market.

"The RAFI methodology is big on rebalancing," Carver said. "And we're big rebalancers. We rebalance all the time. That's Arnott's point: It's a mathematical principle that if you have volatility, it's smart to rebalance."

 

Do-It-Yourself Alpha

Many advisors whose minds are indeed open to alternative-beta products eschew the broader brush strokes of ETFs like PRF or the WisdomTree Emerging Markets Equity Income Fund (DEM | D-76) or even the First Trust Large Cap Core AlphaDEX Fund (FEX | B-69).

Instead, they seek to create their own portfolios that outperform broad-market benchmarks such as the S&P 500 Index using smart-beta funds to achieve that objective. They do use broad and ultra-cheap cap-weighted index funds for the core of a portfolio, but add smart-beta funds with factor tilts on the perimeter—say low volatility, momentum or perhaps quality.

"The portfolio should tell the story," said Scott Kubie, chief investment strategist at Omaha, Neb.-based CLS Investments. "If you look at your portfolio and you have an overweight in growth because you want to add momentum, why not just own momentum?"

"That's a clear communication of how much your allocation is to yourself. But it's also a clear indication to your clients that this is what's going on in my portfolio, these are the things I'm emphasizing. I think that's a better way of doing it," Kubie added.

He said multifactor alternative beta funds with indexes from, say, Research Affiliates or WisdomTree are really meant to replace core exposure, and that's not the way he builds portfolios.

"If I were a passive investor who didn't ever trade and who didn't want to add things that added a little value, I'd be a lot more interested in the RAFI or WisdomTree products for a larger allocation," noted Kubie.

Instead, Kubie said he owns ETFs zeroing in on momentum, quality, value and minimum volatility. "Those four are the strongest ones out there. We're an active manager and we want to target what we want to own, and we want the option of moving out of it."

 

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