The long-term tide may be turning against your traditional market cap weighted index fund. Or at least that’s the story according to the growing group of supporters of “smart beta” and enhanced indexes. This new crop of funds is taking aim at the “establishment” by using active management strategies in order to create new indices designed to enhance returns versus these traditional index funds.

While it may seem confusing at first, the ideas behind smart beta are actually quite simple. And for investors, these alternative indexes can be a portfolio life saver and provide just enough extra returns to make it through retirement.

On the other hand, they can be a major pitfall if you bet on the wrong horse.

So what exactly are these smart beta exchange traded funds (ETFs) doing differently? And how do you choose if these funds are right for you?

Creating A Smart Beta Alternative Index

Since the dawn of indexing and funds like Vanguard S&P 500 ETF (NYSE:VOO), the focus has been on weighting stocks according to their total stock market value or market capitalization. This puts more investor exposure towards the largest company than the smaller. In the case of the venerable S&P 500, Exxon Mobil (NYSE:XOM) and its $364.24 billion market cap gets more weighting than AutoNation (NYSE:AN) and its $4.9 billion market cap.

Broad bond indexes are weighted in a similar manner—by focusing on the amount of debt issued. Commodity indexes are weighted by how large the respective commodity market is.

Smart beta proponents see a few major issues with this. First, Exxon’s individual returns can pull the index much more than the smaller constituents. Even if AutoNation has a knock-out quarter it’s pretty meaningless if Exxon is doing poorly. That brings us to the second strike against a traditional market cap index; along with all the “good” companies, you get the “bad” ones as well. That has the potential to drag on market-beating returns.

Finally, these market cap weighted index funds also tend to overweight overvalued securities and underweight undervalued ones. As investors pile into a stock, its market cap rises and pushes towards a higher place in an index. This may create a 2% return drag in developed markets, or even more in less efficient emerging markets.

Smart beta proponents argue that over time these factors have made traditional market cap indexes a real drain on investor’s returns. In order to combat these issues, fund sponsors have rolled-out new products that tweak these conventional market measures.

To accomplish, this smart beta indexes use various screens and filters to create a new index. These screens look for factors like rising sales, earnings, book value, dividends or cash flows. Some smart beta funds simply equally weight all the constituents in a traditional market cap-weighted index. This way Exxon makes up the same amount of the S & P 500 as AutoNation. Other smart beta funds look at volatility or momentum to create their indexes.

The overall point is to capture more of the upside of the market while alleviating some of the downside. So far, some of these funds have been quite successful at doing just that.

Smart Beta Outperforms—With A Few Caveats

Studies have shown that smart beta is actually pretty smart for portfolios. One report prepared by Vanguard showed that some smart beta funds had over twice the return compared to the traditional market-cap weighted indices.

Analysts estimate that much of the outperforming by the smart beta set has to do with the fact that these alternative indexing methodologies tend to focus on small-cap and value stocks. Or in some cases both. There’s been plenty of academic research that has shown that small-caps and value stocks have outperformed the broad market over a longer period of time.

That’s all well and good, but some have expressed worry that a smart beta crash might loom in the future. Research Affiliates, a U.S. company that developed some of the world's first smart beta indices, published a report titled "How can smart beta go horribly wrong?" which explains why they think there's a reasonable probability of such a crash, and much of it has to do with the popularity of the funds.

Finally, smart beta funds simply cost more, although that may not matter too much if you bet on the right smart beta fund. Choosing an overly complicated fund that doesn’t meet its goals and those higher costs could zap whatever returns you are getting.

So Should You Bet On Smart Beta?

For investors looking to perhaps enhance their portfolios, adding a dose of smart beta may make sense. I just wouldn’t abandon my traditional market-weighted index funds just yet. There’s not enough evidence of the entire strategy set working out as planned. But, as a satellite position or two, smart beta can provide plenty of extra “oomph” to a portfolio.

The key is focus on funds that are easy to understand.

An easy rule of thumb is – If it seems too complicated and good to be true, it probably is.

The Bottom Line

Smart beta and alternative indexing can be a powerful tool or a complete minefield. For investors, the key is keep it simple, use them strategically and not let them have too much weighting in their portfolios.

The author did not own shares of any company mentioned in this article at the time of writing.

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