Non-market cap weighted ETFs (bond, fund, investment, Vanguard)

[cfa-ish]

Are there any ETFs that are not market-cap weighted and that you like or own? If yes, why?

I moved a bunch of money to RSP (equal-weighted S&P 500 index ETF from Guggenheim). The 0.4% expense ratio is a little stiff, but its performance compares well with SPY.... for the last 10-12 years, may not in future.

Malkiel's monkey's alpha made quite an impression on me (see The Surprising Alpha from Malkiel). The paper basically argues that FF4 model (beta, value, small size, momentum) explain most returns, so market-cap weighting, which overweights big growth stocks, is the worst weighting strategy. (I am simplifying a bit.)

However ... authors on Vanguard website have come out swinging against that approach. They argue that market-cap weighting represents the sentiment of the, well, market as a whole, and is key to matching market performance. Which may be true, but that doesn't prove (to me) that a persistent winning approach is impossible. They present this (Introducing Vanguard’s new AlphaBet ETFs | Vanguard Advisors Blog) as a sarcastic example. But it actually works.

[SportyandMisty]

In The Surprising Alpha from Malkiel, the authors note, regarding equal weight funds:

These findings should remind investors to be cautious about benchmarks and portfolios that deviate from a cap-weighted index because the excess returns arise primarily as a result of increased exposure to well-documented risk factors—namely, value and size. CAPM alpha and investment themes are not what drive the excess returns on the studied portfolios. Instead, the inherent and often unintentional slant toward value and small-cap stocks produces the returns. This value and size tilt exists even if a portfolio is constructed to capture strong earnings growth.

[SportyandMisty]

Since you're interested in the Fama-French model (with the momentum enhancement that was the basis of Fama's famous student Cliff Asness' PhD dissertation and also separately found by Sheridan Titman and Narasimhan Jegadeesh), you may be interested in Asness' work on risk-parity investing. The basic idea is that in a 60/40 portfolio, the vast majority of the risk (variance) comes from the 60% equity position. Have you really diversified if 90% of the risk of your portfolio is coming from one of the asset classes?

Asness shows that you can BOTH reduce your portfolio risk AND increase its returns, so the 60/40 portfolio is not on the efficient frontier. The idea of risk-parity investing to to allocate risk rather than dollars. When you allocate by dollars, you say in essence "I'm going to put money into equities until it gets to x% of my portfolio" where x% is your target asset mix. Instead, you allocate risk: "I'm going to put money into equities until it reaches X% of the risk of my overall portfolio". You'll end up with fewer of your dollars in equities because equities are quite risky.

The consequence is the expected return of your portfolio will be lower than a 60/40 portfolio because fewer of your dollars are in risky equities and more of your dollars are in relatively safer bonds - but the variance (risk) of the equity component will be about the same as the variance (risk) of the bond component of your portfolio.

There are only 2 ways to increase the return of this portfolio: (a) sell bonds & buy equities, but this gets you back to the 60/40 problem: a higher portfolio expected return but you've got way too much of your portfolio risk in the equity component, or (b) borrow funds and then buy more of the total portfolio.

See

https://www.aqr.com/cliffs-perspecti...we-fight-lever
http://www.econ.yale.edu/~af227/pdf/...20Pedersen.pdf
http://pages.stern.nyu.edu/~lpederse...gainstBeta.pdf
https://www.aqr.com/library/aqr-publ...if-yields-rise
https://www.aqr.com/library/journal-...-not--equities

[oneslip]

I like the blended approach - RSP and SPY. Although the VTI could work well giving more of a smaller cap weighting.

[cfa-ish]

Originally Posted by SportyandMisty

Since you're interested in the Fama-French model (with the momentum enhancement that was the basis of Fama's famous student Cliff Asness' PhD dissertation and also separately found by Sheridan Titman and Narasimhan Jegadeesh), you may be interested in Asness' work on risk-parity investing. <snip>
See

https://www.aqr.com/cliffs-perspecti...we-fight-lever
http://www.econ.yale.edu/~af227/pdf/...20Pedersen.pdf
http://pages.stern.nyu.edu/~lpederse...gainstBeta.pdf
https://www.aqr.com/library/aqr-publ...if-yields-rise
https://www.aqr.com/library/journal-...-not--equities

Just a quick note, still going through and digesting the links you posted. Risk parity is a novel concept for me, thanks for introducing it! I'll post more when I know what it is all about and if it gels with my understanding.