It’s hard to not find a story about smart beta investing in the financial press these days. But what exactly is smart beta? And are exchange-traded funds (ETFs) that follow smart beta strategies a good idea for investors?

Let's start with the basics. (For more, see: Smart Beta Funds vs. Index Funds.)

What is Smart Beta?

There are many definitions of smart beta, but the ETFs that are classified as smart beta generally use a method that tracks a market index in a fashion unlike the traditional market capitalization that weights traditional index funds; the strategy adds a handful of additional screens to the list of securities a particular fund might purchase. 

Managers of smart beta portfolios may use an equally-weighted indexing approach or one that is weighted based upon a fundamental approach, such as earnings or book value vs. the traditional cap-weighted approach. (For more, see: Smart Beta ETFs Strategies.)

Smart Beta Strategies

Some smart beta ETFs follow a strategy designed to enhance returns. An example is a dividend-oriented ETF that weights its holdings by screening for dividend levels or dividend growth. Other smart beta ETFs focus on reducing risk. Examples of this include low-volatility and high-beta strategy ETFs.

Other ETFs don’t fit into either the enhanced return or risk-control camps. These include ETFs that track commodity benchmarks or employ multi-asset based strategies. 

Many of these ETFs are relatively new and have come into existence since the bottom of the last financial crisis. Many were developed via back-tested data without performance data based on actual stock market returns.

These reconfigurations of traditional indexes appear to be a means for the issuers to charge higher expense ratios than they would for a traditional market cap weighted ETF.

Some of the known cautions of smart beta ETFs include the fact that most of the results of the various smart beta strategies are back-tested. It has not been proven whether these strategies will work with large amounts of money to invest. Additionally, the trading costs to rebalance to these modified indexes may end up being more costly than thought. Trading costs can drive down simulated results significantly and lessen the strategy’s value to investors.

Smart Beta Pros

One of the arguments for smart beta strategies such as equal weighted indexing is that they remove the emphasis on the stocks in the index with largest market cap weightings. When these stocks underperform, they will have a sizable impact on the performance of the index relative to the smallest components of the index.

Smart beta is not a passive strategy like the traditional market capitalization weighted index funds. While many smart beta ETFs have higher expense ratios than passive index products, they are cheaper than most actively managed funds.

Wisdom Tree lists four potential advantages of smart beta strategies:

  • Enhanced portfolio returns
  • Reduced portfolio risks
  • Increased dividend income
  • More efficient exposure to the equity risk premium

Smart Beta Cons

According to ETF.com, there are four risk factors that investors need to be aware of when considering smart beta ETF strategies:

  1. False Alpha. The factors that might cause a given ETF to outperform a traditional index like the S&P 500 when the markets are rising might also cause a given ETF strategy to have its own unique risks on the downside. These factors might cause the ETF to underperform by more on the downside than its upside outperformance.
  2. Crowding, or too much money chasing a strategy. Low volatility was a hot smart beta strategy a couple of years ago. As more money poured into these ETFs, the performance gap with the S&P 500 narrowed and eventually, as a group, they underperformed the index.
  3. Tracking error. ETFs tracking plain vanilla indexes like the S&P 500 generally underperform the underlying index by the amount of their expense ratios. Smart Beta ETFs will often trail their benchmarks by more than that due to a need to rebalance to these indexes more frequently. For example, the Guggenheim Equal Weight S&P 500 ETF (RSP) trails its benchmark by almost 50 basis points, more than its expense ratio would indicate.
  4. Trading issues. Some of these smart beta ETFs don’t trade as readily as plain vanilla index products like the SPDR S&P 500 ETF (SPY). Due to their non-standard nature, the execution price of a trade may drift a bit from the underlying fair value of the ETF.

Cullen Roche, a popular financial blogger at Pragmatic Capitalism, puts his opinion of smart beta investing this way: "I am generalizing, but I tend to believe that factor investing is just a new, clever way to get people to pay higher fees for owning index funds."

The Bottom Line

Some say smart beta ETFs are just a gimmick and another way for ETF providers to gather assets with higher cost vehicles than traditional passive market cap weighted index ETFs. Many are popular with institutional investors; that seems to be where the biggest interest lies, however the number of smaller investors are growing. Financial advisors may use these products directly or via ETF strategists. In both cases, they should understand how these smart beta strategies work and why or if they will provide more value and enhanced returns or lower risk for their clients. 

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