How to Create a Smart Beta Index?

In the last set of slides, we introduced the notion of smart beta which was an implementation of the screening strategies we had talked in previous videos and ETFs that are based on these indices. These permit individual investors to access screening strategies that would be difficult for them to implement on their own. There are two primary types of these ETFs. The first is an absolute smart beta strategy. The second is a tilt toward smart beta.

In this video, we will walk through the creation of an absolute smart beta index for the illustrative purposes of understanding how an investor would be able to invest in such an ETF. For the purposes of this exercise we are going to look at a momentum index. Momentum is the tendency of past winners to perform relatively well and past winners to perform relatively poorly. This is typically measured by past 6 to 12-month returns relative to other stocks. And it’s a very popular quantitative strategy amongst hedge fund managers. As a reference we’ll be using the MSCI Momentum Index.

These consist of mostly large and mid-cap stocks that are constituents of the MSCI USA Index that also within the index have the best 6 and 12-month past returns. This covers approximately 30% of the market capitalization of the MSCI USA Index.

For illustration I have listed here the top ten holdings of the MSCI USA Momentum Index with the weights that they have in the Momentum Index and the weights that they have in the MSCI USA Index. The highest weighted stock as of this recording was Procter & Gamble with a momentum index weight of 5.26%. This is compared to the index in the MSCI USA Index of 1.13%.

The point here is to note that Procter & Gamble presumably due to its past return performance has been weighted much more highly within the Momentum Index than in the MSCI USA Index. All ten of these stocks have considerably higher weights in the Momentum Index than the MSCI USA Index. The only stock that is fairly close is Microsoft which has a weight of 5.09% in the Momentum Index and 3.79% in the MSCI USA Index. In order to understand how MSCI would create such an index we are going to create a pretend index and momentum index for the purposes of illustration. We’ll use a smaller index so that we don’t have to use as many firms.

And the basis for our index will be the ten largest firms by market capitalization as of December 31st, 2018. We will calculate the return over the period 1/1/2018 through 12/31/2018 to get their past 12-month return. We’ll compute the market capitalization at the end of 2018 and resulting weights and

then form a portfolio which we’ll refer to as the Big 10 Index. Our Momentum Index will hold just the winners within those ten stocks, the top 20% or two firms.

In this table, I have presented some information about the ten largest stocks at the end of 2018. I have the name of the stock. I have its market capitalization. It’s resulting weight in the Big 10 Index. How that stock returned in 2018 and what its rank was amongst the ten stocks.

You can see that the largest stock in this particular portfolio is Microsoft with a 16% weight and the smallest is Walmart with a 5.7% weight. The best performing stock on a momentum basis, that is to say, the last 12-month returns is Amazon which returned 28.43% and the second-best performing is Microsoft which returned 20.72%. Our momentum portfolio will hold just these two stocks instead of all ten stocks within the index.

The top two firms within the index in terms of past performance Microsoft and

Amazon have a combined 31.8% market capitalization of the total index (1.5 trillion / 4.7 trillion). And so when we create our momentum index we will hold just these two stocks and hold them according to their market capitalization weights within the index of the two stocks. So Microsoft with a market capitalization of about 780 billion will have a weight of 51.5% which is 780 billion divided by 1.513 billion.

And Amazon will have a weight of 48.5% which is its market capitalization of 734 billion divided through by the total market capitalization.

Just for fun let’s see how the different indices fared over part of 2019.

These are returns through August of 2019. Again, the weights on the index would not have changed because they are value weighted. And so as a result the Big 10 Index had a pretty healthy return of 21.5%.

With the best performer being Facebook with an increase of 40% and the worst performer Berkshire Hathaway which lost 2.4%. Our Momentum Index also fared quite well earning 29.3% as compared to 21.5% on the underlying index. This, of course, is not guaranteed but is something that we might hope given that past winners have a tendency to outperform past losers. If we were doing this in real life the weights and rankings would be updated periodically to reflect past 12-month performance. And new stocks could potentially come into the index if their performance was strong. So for example, Apple and Facebook both performed well over the past 8 months and

so potentially could wind up in some sort of a momentum index. A momentum index will hold stocks with the best recent past performance within an index. From this index an authorized participant could create an ETF as we’ve discussed in previous videos. These indices would allow individual investors to participate in momentum strategies. Our next video we’ll discuss a variant of this type of strategy, a smart beta tilt index and ETF.