The Problem With Designer ETFs

Includes: PRF, SDY
by: Timothy Siegel

The exchange traded fund [ETF] world has blossomed with the introduction of designer exchange traded funds [ETFs] that apportion their holdings according to some statistical process other than mere market cap. There are ETFs from Wisdom Tree that apportion their holdings according to total dividend payments.

Along similar lines the SPDR Dividend ETF (NYSEARCA:SDY) invests in the 50 highest-yielding companies in the S&P Composite 1500 that have consistently raised their payouts for at least 25 years. On the other hand, the PowerShares FTSE RAFI US 1000 (NYSEARCA:PRF) evaluates the 1,000 biggest U.S. companies on the basis of average sales and cash flow over the previous five years, total dividends distributed over the previous five years and latest book value (assets minus liabilities) and apportions its holdings according to a formula based on these factors.

There is a basic philosophical problem with all of these funds. Apportioning according to market cap mimics and therefore accepts the actual distribution of money in the market. This distribution, just like the price of every stock, is that which those with the most money invested have made it. Those with the most money invested, unsurprisingly, have typically hired the best minds, with the most time and the best training to make the investment decisions that have resulted in the relative market caps of the various stocks. Using a statistical guide for the distribution of money into stocks suggests that this process has been inefficient.

The designer ETFs take a subset of the information that has been analyzed by the investors who have set the distribution of market caps, in an ever changing dynamic process. They then take this subset of available information and apply a rigid formula to it. And they appear to believe that this distribution, based on a subset of information and devoid of an ongoing application of human judgment can beat a process based on the full set of information and constantly informed and updated by skilled human judgment.

I don’t buy it.

Now I do swear to you, the reader, that when I began to write this journal entry I had not checked the performance of SDY or PRF. I picked them at random from a short list of designer ETFs. I have just checked performance and over the past two years they have both been beaten by the S&P 500 index. PRF was beaten by about 5%, whereas SDY was absolutely clobbered by roughly 20%. I did not take out the management fees of SDY or PRF, but also did not add in the dividends one would receive if holding the S&P 500. Clearly this is a quick analysis based on only two randomly selected designer ETFs. Nevertheless it tends to bear out my point. You can’t outsmart the market by basing your distribution of money between stocks on a rigid computer analysis of part of the data. It just does not make sense.

Now we all know that in March of 2000 the largest of the large cap stocks were overvalued. Since that time an S&P 500 index in which each stock was equally weighted has far outperformed the actual S&P 500 index in which each stock is weighted according to its market cap. But the designers of the designer index funds are not the only ones who have noticed this phenomenon. There is every possibility that the current market caps in the S&P 500 have been strongly influenced by this past overvaluation. Perhaps the market has actually overreacted. It is possible that the present valuations actually undervalue the largest large cap stocks. But let us theorize that there actually is some attribute of investor psychology which causes the largest large cap stocks to be consistently overvalued. If this were to be the case, surely a better way of addressing this issue would be to apply a secondary weighting to the market cap weighting, which would cause the largest large cap stocks to be weighted slightly lower than they would be in a straight market cap rating. I’m not recommending it, except for as a more sensible alternative to ranking by dividend payments or any other subset of the available financial information.

Market cap is a function of democracy, except for resulting from a process in which each dollar, rather than each eligible person, gets a vote. So Winston Churchill’s famous aphorism about democracy, that it is absolutely the worst system of government, “except for all the rest,” holds true in this context.