Smart beta funds that exploit factors such as momentum and growth to beat the market have become wildly popular, accounting for half of all U.S. ETF inflows in 2018, per a Deutsche Bank report released last week. However, their approaches have posed major overlooked risks to investors, according to several experts, as outlined in a recent Barron’s story.

5 Risks Smart Beta Fund Investors Should Know About

  • Factor ETFs may pick up junk stocks
  • The same valuation metric not ideal or applicable for different companies
  • Funds could be disproportionately exposed to certain sectors
  • Momentum stocks can soar, and then see gains disappear quickly
  • Multifactor ETFs may inherit hidden risks or not get exposure to factors they want

Source: Barron’s

Smart beta ETFs employ many of the same proven strategies exploited by quantitative funds and active managers. The newly popular ETFs are more straightforward and offer services at a cheaper price to investors, yet their rules-based system makes for a concerning amount of rigidity.

"The real challenge for smart-beta investors now is that they see a lot of options on the menu, whose names seem very similar but have very different risk and return profiles, depending on the nuances in the construction of their underlying index,” said Ben Johnson, director of global ETF research at Morningstar. He warns that investors need to apply the same level of due diligence to smart-beta strategies as they would to actively managed funds, which allow managers more discretion.

Factor ETFs Vulnerable to Junk Stocks

Experts cite risks including value factor ETFs, which pick the 100 cheapest stocks within the S&P 500 based on price/book ratios. These may unintentionally load up on shares of companies that are cheap for good reason, known as junk stocks. This reflects the greater issue among factor ETFs, which by focusing on one metric may overlook another important factor like company fundamentals.

Valuation Metrics Don’t Suit All Companies or Industries

Secondly, in the scenario above, the price/book ratio might not be applicable for companies with large intangible assets, such as technology, patents, and brand reputation. Since different sectors find better use for valuation metrics, using one to examine a wide range of industries could have major flaws.

Beta-Funds Could Disproportionately Invest in One or a Few Sectors

Factor ETFs could also be too heavily weighted one or a few sectors, spelling bad news for an industry-specific downturn and creating an imbalanced portfolio. For example, low-volatility funds could carry big downside potential, given they don’t impose limits on sector size and therefore may be overweight in a few defensive sectors such as utilities, real-estate investment trusts, and consumer staples, per Barron’s. In the case of rising interest rates wherein fixed-income investing becomes more attractive, these “bond proxy” sectors typically get burned.

Momentum Has Its Downside

Banking on momentum can also be a tough factor for ETFs to generate outsized returns from, given the fact that while momentum stocks can soar during the first month, the gains can disappear quickly. According to research from Dimensional Fund Advisors, 30% of the stocks in the S&P 500 with the highest momentum on average outperform the index by 35% points one month after entering that top percentile. In just one year, the average company loses all of its recent gains. Given many momentum ETFs don’t act as fact, rebalancing an average of twice per year on fixed dates, they could miss out on potential for returns.

Multi-Factor Funds Complicate

Then there’s the option to invest in multi-factor funds, which promise exposure to different factors. Investors in these funds might be taking on unmentioned hidden risks, or not getting enough exposure to the factors they want the most, according to Tom Idzal of factor-software analysis company Style Analytics.

Looking Ahead

Ultimately, while the goal of smart beta investing is to achieve higher than expected returns, investors will need to be extremely cautious on hidden risks factors. Moving forward, the use of data and technology will continue to take over the function of what were traditionally active portfolio managers.