Revamping ETFs: Exchange-traded funds are undergoing a bit of a renaissance, with new styles of indexing. How smart is smart beta?

Revamping ETFs

Exchange-traded funds are undergoing a bit of a renaissance, with new styles of indexing. How smart is smart beta?


May 10, 2014 2:23 a.m. ET

Smart beta. It’s the ETF industry’s version of “New! And improved!”

Most of us range from fairly skeptical to deeply suspicious of any marketing terminology when it comes to buying cars or homes or Google Glass. But that doesn’t stop Wall Street from peddling one elixir after another, wrapped in academic research and carefully worded nonpromises. The latest? Smart beta, an umbrella term for index investing designed to beat the market, rather than simply match it.

The $1.7 trillion exchange-traded-fund industry has flourished under the halo of index investing, beginning the way index mutual funds did — by offering low-cost, broad indexes that allowed investors to achieve market returns. Next came finer and finer cuts, products that focused on companies of a particular size, in a specific industry, according to geography, or with certain characteristics, such as dividend-payers.

Now, there are nearly 1,300 ETFs linked to some kind of an index. And the fastest-growing segment — some 353 ETFs with $320 billion in assets, according to Morningstar — is what the research firm calls strategic beta.

Smart beta, strategic beta, rules-based, fundamental, enhanced — the marketing swirl around this new style of indexing is in overdrive. For the most part, the terms all refer to alternative means of indexing. Traditional indexes, like the Standard & Poor’s 500 and Russell 2000, were created to measure large swaths of the market. As such, they are structured the same way the market is — according to market value. The biggest companies represent a proportionately large weighting in the index.

Generally, the new indexes borrow the low-cost, buy-the-market halo of traditional indexing, but are structured in a way that attempts to beat the market. Barron’s decided to explore these new strategies.

Parsing the marketing terms may seem like semantics, but semantics was the source of a years-long lawsuit between two of the firms represented on our panel — Research Affiliates and WisdomTree Investments (ticker: WETF). Both claimed to have invented fundamental indexing, which weights companies according to various stock attributes, 10 years ago. A 2012 legal settlement carved up the fundamental-indexing landscape, with WisdomTree pledging to use no more than two factors in its index–building (such as dividends and earnings for its stock ETFs), while Research Affiliates would use three or more, incorporating other factors such as book value and cash flow. The deal left its mark on nomenclature, too: WisdomTree no longer uses the term fundamental.

To help investors navigate these new products, Barron’s asked representatives of WisdomTree and Research Affiliates and two other firms that offer different approaches to indexing to join a roundtable, along with an independent financial advisor who has performed extensive research into how these indexes tend to perform.

Chris Brightman is the chief investment officer at Research Affiliates. The firm, launched by Rob Arnott in 2002, doesn’t manage any money directly but licenses its indexes to a variety of ETF providers, including Invesco, Charles Schwab, and Pimco. That arrangement leads to some lengthy fund names: The first product to be built on a Research Affiliates Fundamental Index (RAFI) is the $3.3 billion PowerShares FTSE RAFI US 1000 (PRF), launched in 2005. There are now 39 RAFI-based ETFs and mutual funds with $56 billion in assets.

Luciano Siracusano is the chief investment strategist and head of sales for WisdomTree Investments, which launched its first funds in 2006 and now manages $33 billion in 69 ETFs. Siracusano and WisdomTree founder Jonathan Steinberg created the firm’s first indexing strategy; hedge fund manager Michael Steinhardt and Professor Jeremy Siegel, of the University of Pennsylvania’s Wharton School, provided early financing and still lend their investment expertise.

Fran Rodilosso is Van Eck’s senior investment officer for fixed-income ETFs. Van Eck Global, founded in 1955, is perhaps best known for being the first to launch a gold-equity mutual fund and a hard-assets fund (for commodity-related stocks), and is among the pioneers of international investing. Van Eck manages $33 billion, $23 billion of which is in 58 ETFs, sold under its Market Vectors brand.

Jared Kizer is director of investment strategy for the BAM Alliance, a collection of 140 independent investment advisory firms with $23 billion in assets under management. Kizer is also director of investment strategy for BAM’s primary firm, St. Louis–based Buckingham Asset Management, which oversees more than $6 billion.

Maz Jadallah, founder and chief executive of AlphaClone, pioneered the use of hedge fund public disclosures to create stock indexes. His ETF is the $86 million AlphaClone Alternative Alpha ETF (ALFA), launched in 2012.

Barron’s: Let’s start with the jumble of words used to describe the new style of indexing. Alternative, fundamental, rules-based, strategic beta, or, perhaps the most common, smart beta — what does all this mean? What do investors need to know?

Jared Kizer: This whole notion started in the early 1990s, with Eugene Fama and Ken French, two academics who determined that small stocks and low-priced, or value, stocks beat the broad market over the long term. That was the big launching point for tweaking cap-weighted indexes. Now there’s an explosion of products with different terms — which all mean roughly the same thing, just “not traditional” — and it is very difficult to sort through all of that.

Luciano Siracusano: Smart beta is a clever phrase in search of an enduring definition.

Chris Brightman: The traditional concept of an index is a broad measure of the market, with securities weighted according to their market value, or capitalization. That’s still the proper methodology for measuring the return of the market. But it may not be a good investment strategy.

What’s wrong with the standard capitalization-weighted index? Plenty of research has shown that most investors fail to beat the S&P 500 or other market benchmarks.

Maz Jadallah: The explosion in ETF assets has been driven by the fact that, even though broad, cap-weighted indexes don’t provide the highest returns possible, very, very few active investors manage to beat them. That’s true for mutual funds and increasingly true for hedge funds. So there’s this search to take this technology — because that’s what ETFs are, a technology — and create a strategy that insulates investors against behavioral risks, like buying and selling at the wrong time.

Fran Rodilosso: We are at a very early stage in these alternative indexes — even more so on the fixed-income side. Alternative bond strategies can be more difficult to execute because of challenges, such as less-liquid securities, which lead to higher transaction costs.

Siracusano: The trade-off in indexing over the past 25 years has been between representing the market and investibility. There is plenty of evidence that fundamentally weighted indexes give you higher returns, lower volatility, or both.

What do you mean by “fundamentally weighted?”

Jadallah: Fundamental refers to the underpinnings that drive a company’s success — such as cash flow, earnings, sales, book value.

Brightman: In a capitalization-weighted index, the highest-priced securities are the biggest percentage of the index. You’re buying high. Just deviating from that provides a return advantage. Even a simple equal-weighted S&P 500 index produces a return that’s more than two percentage points higher than the cap-weighted S&P 500 index; the same is generally true with regard to most countries’ indexes. And there are many ways to improve upon equal weighting.

Siracusano: There is no free lunch when it comes to indexing. An equal-weighted S&P 500 index has 30% in companies that are normally characterized as mid-cap. Once you compare it to a mid-cap index, you might not see much outperformance at all, and when you account for the higher volatility that mid-cap exposure brings, you may not have generated better risk-adjusted returns. There are always trade-offs.

Brightman: And almost all active managers insist on being measured against a capitalization-weighted index, despite the fact they equal-weight the securities in their portfolio. The many studies that demonstrate how most actively managed funds underperform the capitalization-weighted index would be even more shocking if we compared those active managers to an equal-weighted index. This notion of manager skill, or stock-picking skill, is probably even more scarce than people realize.

You all offer ETFs that involve more than simply equal-weighting holdings. WisdomTree and Research Affiliates pioneered the specific notion of weighting stocks according to company fundamentals. How does that work?

Siracusano: WisdomTree uses cash dividends or earnings to weight the stocks in our ETFs. There are $360 billion of dividends paid in the U.S. today and more than $1 trillion worth of earnings. Instead of buying the equity market based on what people have paid for it previously, which is market capitalization, you buy each company in proportion to its contribution to that income stream or earnings stream. When you weight by dividend, you get a higher yield; weighting by earnings gives you a lower price/earnings ratio. That all leads to an advantage on valuation. At the end of the day, the total return of any equity market is driven by the change of valuation, along with the starting dividend yield and growth in aggregate dividends.

Rodilosso: You can’t quantify all outperformance. There are fundamental factors that aren’t as tangible or measurable, and almost every factor has an element of looking back.

Kizer: I haven’t looked at every single fundamental index, because there are a gazillion of them at this point, but in most cases, fundamental weighting just gives you a value tilt or a small-cap tilt, or both. That’s not necessarily a bad thing, but they’re being sold as “new and different,” when many are not.

Rodilosso: Also, with many fundamental strategies, you’re shrinking the universe. You’re giving up diversification.

Siracusano: Our universe is the 2,000 profitable companies in America with $20 trillion in market value — that’s broader than most cap-weighted indexes.

Fran, Van Eck’s ETFs are not fundamentally weighted; many are capitalization-weighted, but include other criteria that make them unique. Many seem more about security selection than reweighting the market.

Rodilosso: Yes, many of our indexes are cap-weighted, but we limit a particular issuer’s weight in many cases — especially in fixed-income products such as emerging markets and high yield, where a large market cap could indicate problems.

Maz, your AlphaClone Alternative Alpha ETF is different in that instead of indexing stocks according to their characteristics, you choose the stocks owned by hedge fund managers that have outperformed over the long term.

Jadallah: Yes. You can parse their returns over as many different factors as you want and there’s still that little indefinable piece that is skill, or alpha. Instead of indexing stocks based on their fundamentals, we index managers who are fundamental investors. We include managers who have shown skill in selecting between the different betas, or long-term market trends, over a long period of time.

How do you determine that?

Jadallah: Hedge funds disclose their positions quarterly, and their holding periods are a lot longer than most people think — a year, on average, and much longer in many cases where the manager has high conviction. The regulatory disclosures only name the long positions, but our research shows that in the case of managers who outperform, the skill is typically on the long side, not on the short side.

So you invest in the stocks disclosed in the quarterly reports.

Jadallah: We score the 500 managers in our universe every six months based on how well their disclosed positions perform. We then pick the managers with the highest scores and aggregate the highest-conviction ideas into one portfolio. The ETF typically has 80 stocks.

These strategies can get confusing quickly. What’s the bottom line for investors?

Rodilosso: Investors need to ask: How smart is this index? Is it making a valuation judgment to choose the “best” companies, or is it taking a standard index and simply changing the weights? Some companies are cheap for a reason; some companies are worth owning even if they’re pricier. Is the index just finding the cheapest companies, or is it paying any attention to who are the best issuers?

Kizer: Investors lose a lot of return to bad behavior. It’s crucial they stick with a strategy. Investors lose 1.5% a year to performance chasing — that’s based on a Morningstar study comparing mutual fund returns with fund-investor returns. Investors don’t, on average, get the same returns the funds themselves do, because they’re moving in and out at the wrong times. We call it the behavior gap. No matter how well designed an ETF is, how the individual investor actually uses it is crucial.

Brightman: There is a lot of performance-chasing, but performance-chasing creates an opportunity for contrarian investors. But the strategies should be sound for the long term, not niche-y products that encourage people to do counterproductive trading.

Agreed. But how can an individual investor evaluate these different indexes?

Siracusano: You need to look at the funds, not just the indexes. The funds have expenses, transactions fees, and, in some cases, tracking error. You can have a great index, but if you can’t actually replicate it with a bunch of securities, and the performance of the ETF trails that of the index — known as tracking error — you haven’t achieved what you set out to achieve.

Kizer: When evaluating a new strategy, we want to see that a style or factor or whatever that is driving the outperformance has been shown to work in the U.S. markets, international markets, and across asset classes, and has been demonstrated by multiple researchers, both academic and practitioner. That gives us a lot of confidence.

That sounds more like an advisor’s job.

Kizer: Yes, it does get a little bit technical, but any advisor can do it; the data are just sitting there for free. Take the monthly returns of the strategy, run a Fama/French three-factor regression analysis, and see if you have anything new, or if the outperformance is due to the factors we already know contribute to long-term outperformance — small and value. That’s not something an individual investor should be expected to do, but it’s ground zero for us. We need to understand if we’re really seeing anything new, beyond the small-cap or value tilt.

Are these ETFs better off in the hands of advisors?

Rodilosso: Sometimes, but not all are that hard to understand. We have a two-year-old high-yield corporate bond ETF, the Market Vectors Fallen Angel High Yield Bond (ANGL), based on a Merrill Lynch index that has been around since 2003. Fallen angels are investment-grade bonds that have been downgraded to below-investment grade. By the time a bond falls into this index, it’s been sold heavily; its price has fallen a lot. But the issuers are usually in better financial shape than companies that go into the market as high-yield issuers. The fund has outperformed in both years, and the index has beaten the broad high-yield index in seven of the past 10 years.

Jadallah: You have to make sure you understand the methodology by which a security makes it into the portfolio. Then you evaluate the product, whether it’s liquid enough, what it costs, etc.

Kizer: Use extreme skepticism around any back test. The famous phrase “I’ve yet to see a bad back test” is actually true.

Jadallah: Back-testing gets a really bad rap, and for good reason: It’s easy to make the numbers look good. But knowledge in the investment space has been advanced largely through quality back-testing. The French/Fama paper was nothing but back-testing.

Fama and French’s research spanned decades, and they didn’t start with a preconceived notion of what they’d find. That was academic research, not back-testing. And their research also shows that small or value stocks won’t do particularly well at times. Wouldn’t the same be true of fundamental or other “smart” indexes?

Jadallah: Yes, all factors will underperform at times. We solve that problem by indexing the managers who have demonstrated skill in moving in and out of factor-based market trends.

Siracusano: Most investors understand they need to rebalance; our indexes are going to do that for you. For example: If you bought Japan in 1970, the Japanese equity market was yielding 5%. From 1970 to 1989, yield went down to a half a percent. The annualized returns for that period were 25% per year, in U.S. dollars. Some of that was because the yen appreciated, but most of it was driven by the fact that the equity market did very well, and you bought cheap. If you bought Japan in 1989, the next 25 years were miserable. If you bought a cap-weighted international index fund in 1989, your largest country weight would have been Japan, and it would have been a ball and chain around your neck. If you had dividend-weighted that portfolio, you would have been overweight Japan in 1970, underweight in 1989. Valuation is important — what you pay up front often determines how much you are going to make. It’s not about buying 20 or 30 dividend stocks. It’s about buying all 1,400 of them in the U.S., which gets you about 80% coverage of the Russell 3000, 88% of the S&P 500. Internationally it’s like 90%-95%. This is not a niche strategy.

It’s not niche, but it is contrarian, and that often requires a strong stomach.

Brightman: Our founder, Rob Arnott, has three simple principles of contrarian investing. First, you have to believe that markets aren’t perfectly efficient. Second, you have to realize that opportunities are going to be scary. The opportunity to buy companies cheaply always comes with something frightening about the market. The third principle requires patience and discipline. If you’re going to bail on the strategy after the first two- or three-year period of underperformance, this is not a strategy for you.

Most of you rebalance annually. Why not more often?

Brightman: In the short run, there’s momentum in markets. To trade more often than annually, you’re swimming upstream against momentum. But over the long run, there’s mean-reversion. A fundamental index strategy is taking advantage of that long-run reversion to the mean. Think of it as a rebalancing strategy.

Jadallah: We rebalance quarterly because that’s when the filings come out. Also, our premise supports us rebalancing more often, because the guys we’re following are really good at switching between factors as the market changes.

All of these indexes, no matter how they’re structured, aim to beat the market, which has long been the territory of active managers. If actively managed ETFs gain traction, will that hurt smart-beta ETFs?

Kizer: Actively managed ETFs are just another flavor of active management, and I can’t say they will be that interesting. We know the research; we know why active managers can’t consistently outperform. Why would a different structure change the fundamental dynamics?

Rodilosso: You get transparency as to the holdings, but not as to the manager’s actions and motivations. There is one advantage the ETF structure holds for any strategy, which is potential tax advantages through the creation and redemption process. That shouldn’t be discounted. [ETFs are created when an institution provides the underlying shares in exchange for an ETF’s “creation unit.” A “redemption” is the same procedure in reverse. These swaps don’t incur any taxes.]

Brightman: Too often, we get hung up on semantics. There is a very reasonable argument that anything other than a broadly diversified capitalization-weighted index is active. You have different positions than the market, and that’s active. We need to go back to a simpler concept when evaluating an ETF: Is it transparent? Do you understand why it may or may not work? What are the expenses? How deeply investible is the strategy? You don’t need sophisticated statistical models to figure that out.

Siracusano: The notion that you should “buy the market” is a polite fiction. If you did, you’d have a 50% international allocation, which most advisors wouldn’t recommend. So your starting point is making active bets in terms of allocating relative to the global equity market.

Even so, you need a capitalization-weighted index to represent the market — or parts of the market, such as the S&P 500 for U.S. stocks — to use as a benchmark for all these other indexes.

Brightman: When we start talking about industry terms like tracking error, we are talking about managers managing their business risk — that’s not about helping investors. Investors are looking for long-term wealth accumulation, not managers who are closely tracking a particular benchmark. Investors need to understand the strategy and determine if it will help them build long-term wealth to meet their goals. That’s how advisors should approach it, too.

Jadallah: There’s a large investment advisor that makes active bets and builds portfolios for clients, and refuses to benchmark performance against anything, because it says the important thing is whether the client is achieving their objectives or not. That is important, but it is also important for the client to understand whether they’re earning your fee. And the only way to do that is to benchmark against something else.

Kizer: You should always evaluate whether lower-fee strategies are outperforming your higher-fee strategies, and if they are, you should ask yourself why.

The Financial Industry Regulatory Authority has warned advisors about putting clients into leveraged ETFs, which are also complicated index products. Do you expect to see more investor protection or even regulation around new ETFs?

Rodilosso: It’s an evolving asset class. The industry may be allowed to do more than it is doing now — not all providers have [Securities and Exchange Commission] permission to launch ETFs that include derivatives or leverage, for instance. If those regulations loosen, that’s where you want to start getting cautious. It’s not that all derivatives are bad, but they’re often misunderstood. And, by definition, derivative use means you are losing the transparency that makes ETFs so appealing.

Siracusano: The most important innovation is the structure itself. If you can get two things right — low fees and minimizing taxes — you’re going to improve returns. The ETF structure enhances both of them.

Jadallah: It is also better than the alternative. How many zombie mutual funds are out there charging large fees and upfront sales charges? Can you prevent bad ETFs or bad ideas? No. Is a five-times levered inverse product a good idea? Probably not. Every investor has to exercise common sense.

Thanks, gentlemen.


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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