Smart Beta ETFs: The Complete Guide

This has prompted fund sponsors to think differently about how they construct various indexes. Today, there seem to be as many funds that examine various factors as there are traditional market cap-weighted indexes. And while “smart beta” may be a new name, its basic tenants have been around for several years.

Navigating the smart beta waters can be tricky but it doesn’t have to be. All it takes is a little know-how and you too can potentially get “more” from your indexing. Here’s ETFdb’s guide to Smart Beta ETFs.

The heart of the smart beta- and factor-investing movement takes aim at the notion that the market cap weighting of indexes is a great way to go about building a portfolio. On the contrary, it’s downright inferior and in some cases caustic to returns.

The problem is that market cap weighting causes investors to overweight their exposures towards the largest firms in an index and underweight them to the smallest. In the case of the venerable S&P 500 index, tech firm Apple (AAPL) and its $741 billion market cap gets more weighting than, say, Diamond Offshore (DO), which has a market cap of approximately $3.5 billion.

Smart beta proponents see three major flaws with this.

Cap Weighting Drawbacks

First, mega-stock Apple’s individual returns can pull the index up or down more severely than the smaller constituents. Even if Diamond Offshore has a knock-out quarter, it’s pretty meaningless if the tech giant is doing poorly.

This brings up the second problem with traditional indexing that smart beta hopes to eliminate: index funds offer instant diversification. Investors get all the stocks, both good and bad, and that’s the problem.

Finally, market cap-weighted index funds also tend to overweight overvalued securities and underweight undervalued ones. One factor that causes a firm’s market cap to rise, thereby commanding a higher place in an index, is investor demand for its shares. While not all stocks at the top of various indexes are “expensive,” they can be. That overvalued nature can burst potential returns as share prices revert to the mean. In the case of the S&P 500, Apple shares can be had for a P/E of 17, while Diamond Offshore is going for a P/E of 10.

With this in mind, smart beta funds use various screens, quantitative rules, and other factors to determine their holdings. They will choose a host index, such as the S&P 500, apply the screens and kick out firms that don’t meet the requirements.

In a nutshell, smart beta and factor investing seeks to blend active and passive strategies.

Fans of smart beta- and factor-based investing argue that over time the various issues with traditional market cap indexes have caused a real drain on investor returns. Smart beta pioneer, Research Affiliates (RAFI), pegs that drag at approximately 2% a year. A research paper produced by RAFI showed that over the long haul, smart beta wins out. From December 31, 1978 to September 30, 2013, the firm’s FTSE RAFI 1000 Index produced average annual returns of 14.09%. The S&P 500 Index only produced 11.98%, while the Russell 1000 Value Index produced returns of 12.52% [see also Comparing Five Years of Alternative Weighting Methodologies].

Over the 35-year period, the RAFI would have turned a $100,000 investment into just under $10 million (approximately double what the S&P 500 would’ve returned). That’s some serious coin.

Backtesting of other smart beta and factor strategies has produced similar market-beating returns. And with retirements lasting longer and various other costs continuing to skyrocket, that can mean the difference between enjoying retirement and not having one.

Given how difficult it is for the average investor to apply a multitude of screens, buy the shares of 100-plus stocks, keep track of it all and rebalance, using smart beta ETFs can be seen as a huge win.

Like everything else on Wall Street, there’s more than one way to skin a cat. Smart beta comes in a variety of flavors, some of which have been around for a long time and have only recently been given the smart beta moniker. Here’s a few of the most popular strategies under this umbrella:

Alternative Weighting Strategies: These are arguably the most basic of all smart beta funds. Index sponsors will take an existing index and rebalance it differently. The most common way is to equal-weight the constituents, meaning that the fund will own the same amount of Apple as it does Diamond Offshore. This helps eliminate many of the issues with traditional indexing.

Volatility Hedged: Over the long haul, the jumpiness or volatility of a stock or asset can also zap returns. These funds try to smooth out the magnitude of asset price fluctuations over time by betting on those firms that don’t jump around as much. Investors are able to capture the bulk of the upside of an index while limiting the downside.

Growth/Value Focus: Traditional value- and growth-style investing has been around since the beginning of stock trading. The problem is that some stocks meet both definitions. For example, the S&P 500 Value Index and S&P 500 Growth index both contain approximately 325 stocks each from the parent S&P 500. That’s a lot of overlap. However, the smart beta twist uses several screens together to find actual “value” or “growth” stocks, thereby offering investors “pure” exposure to the style.

Dividend Weighted: These funds use screens that isolate various dividend and cash flow metrics in order to create their portfolios. Dividend-weighted funds will typically put stocks in order based on yield, strength of payout, or number of years paying a dividend. These ETFs may focus on high income or dividend growth.

Quant-based: The final camp of smart beta funds is a mixed bag. It covers everything from indexes that use a multitude of screens to create rules-based portfolios—to those funds that bet on certain attributes such as insider sentiment or spin-offs from a parent company. It is here that investors will most likely have the hardest time choosing between a promising fund and snake-oil.

While the promise of smart beta is great (who doesn’t want higher returns), the concept can be fraught with misconceptions. Perhaps the biggest is that it is a huge panacea for your portfolio.

One example to the contrary is that various low-volatility funds can underperform in periods of market exuberance. Several such ETFs did fall hard when the Fed began its taper tantrum back in 2013. The problem? Many low-volatility stocks are big dividend payers. The threat of rising interest rates curtailed much of their performance [see also Ten Commandments Of ETF Investing].

This shows another potential pitfall with factor-based investing. Much of the concept’s promise is based on backtesting in a financial lab. One can try and determine every possible outcome, but the truth is that the markets and the people running them aren’t necessarily rational all the time. We can’t really tell how many of these funds will perform well in the real world.

Third, many smart beta indexes rely heavily on “value.” But in periods of rapid expansion when growth stocks are in fashion—as they were during the dot-com days, the run-up to the Great Recession and perhaps today’s bull market-many value-based indices fall by the wayside. That can be a problem for someone about to retire.

Finally, the sheer complexity of creating these indexes increases costs for investors. With the S&P 500 being virtually free to own these days, paying 0.95% a year for a smart beta fund may not seem worth it, especially if the fund doesn’t deliver on its mandates.

While smart beta may be a just a fancy new industry buzzword for factor-based investing, it is here to stay. By using various screens and quantitative techniques, index sponsors are overcoming many of the issues seen with traditional market-weighted indices. However, one must keep in mind that many smart beta funds may not live up to their promise or deliver market-beating returns. They aren’t a cure-all, but in some small doses, they could be just what your ailing portfolio needs.

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Disclosure: No positions at time of writing.