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 indexes 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 firm than the smallest. In the case of the venerable S&P 500, Exxon Mobil (NYSE:XOM) –and its $415 billion market cap- gets more weighting than AutoNation (NYSE:AN) –and its $6.3 billion markets.

Broad bond indexes are weighted in a similar manner- by focusing on the amount of debt issued. Commodity indexes 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 -up or down- 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. According to data by Research Affiliates, this fact creates a 2% return drag in developed markets. 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 XOM makes up the same amount of AN in the S&P 500. Others 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 of the most popular and original funds in the area- the Guggenheim S&P 500 Equal Weight (NYSE:RSP) –has beaten the pants off the traditional market cap weighted S&P 500 index. According to Morningstar, since its inception in April 2003, RSP has produced an average annual return of 11.3%. That’s versus just an 8.4% return for the U.S. stock benchmark. Likewise, the other uber-popular smart beta fund- the PowerShares FTSE RAFI US 1000 (NYSE:PRF) –has produced similar market beating returns.

Analysts estimate that much of this outperformance from 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 not all smart beta funds are set-up to run this way and have fallen flat recently.

For example, the $2.6 billion iShares MSCI USA Minimum Volatility ETF (NASDAQ:USMV) has had some pretty nasty bouts of volatility itself recently. The ETF tries to smooth out ride of U.S. equities by only betting on those stocks who traditionally don’t move around as much. Unfortunately, that creates a portfolio of mostly dividend payers. When the Federal Reserve announced its taper plans, dividend paying stocks became out of favor and USMV actually dropped more than the S&P 500.

This highlights a potential major strike against smart beta- we don’t really know how they’ll perform in the real world. Many of these strategies have been back-tested and created in a financial lab. The case of USMV shows that even though a smart beta fund is designed to do one thing, it may just do another.

Finally, smart beta funds simply cost more. The market cap-weighted SPDR S&P 500 ETF (NYSE:SPY) costs a dirt cheap 0.09%, while the previously mention RSP equal-weighted ETF charges 0.40%. While 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.

Morningstar currently classifies 163 ETFs as having s smart beta strategy and more are on their way. Both the previously mentioned RSP and PRF have relatively simple mandates as does the GARP-styled iShares MSCI USA Quality Factor (NASDAQ:QUAL). Any easy rule of thumb is- If it seems too complicated and good to be true, it probably is. It’s a good idea to pass on the ETF. If that seems too daunting of a task, investors may just want overweight small/midcap as well as value stocks via traditional ETFs. You might just get the same smart beta effects.

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.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

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