Investors frequently ponder the ability of smart beta funds to deliver superior risk-adjusted returns. It is easy to understand why this debate is not likely to end anytime soon. Smart beta critics often assert that fundamentally-weighted indexes take on more risk in an effort to deliver alpha. Said another way, everything is fine and dandy with smart beta exchange traded funds (ETFs) in a bull market, but when the bear comes calling, smart beta funds could be even more vulnerable than their cap-weighted counterparts.

Then there is the issue of costs. While some issuers are driving costs lower, the average annual expense ratio on a U.S. large-cap smart beta ETF is 0.33% per year. Conversely, investors can get some broad market, cap-weighted equity ETFs for as little as 0.03% a year.

Another criticism of smart beta strategies is what some market observers believe to be the primary reasons these funds outperform cap-weighted equivalents. Even some of the pioneers of smart beta believe this investing style, when it does outperform, does so only because of either the size or value factors.

Ask a professional investors why he or she thinks equal-weight funds often top cap-weighted rivals, and those investors are likely to say the size factor, meaning equal-weight's increased exposure to smaller stocks drives out-performance. When it comes to value, it is widely believed value stocks outperform over the long haul, but here critics assert that investors are often late to embracing the value factor and flock to it when there is not much value left.

Risk Reduction Is Important

“FTSE Russell’s 2017 Smart Beta Investor Survey showed that the No.1 objective for evaluating smart beta strategies was for risk reduction, followed by return enhancement,” according to Factor Research. “Naturally there are many types of smart beta strategies available to investors today, however, they are nearly all long-only products. If equity markets crash, then smart beta products will also crash and would not substantially reduce portfolio risks, i.e. fail the investment objective.”

With risk reduction being a top priority for many smart beta users, it is not surprising that low volatility ETFs are among the most popular smart beta products. The PowerShares S&P 500 Low Volatility Portfolio (SPLV) has amassed $7.1 billion in assets under management since coming to market six and a half years ago.

Low volatility strategies remind investors there is no free lunch in financial markets. The trade-off for focusing on reduced volatility can mean returns that lag traditional equity benchmarks during bull markets. To its credit, SPLV has, since inception, had average annualized volatility that is 260 basis points less than the S&P 500. Over that period, SPLV's maximum drawdown was 33% less than the S&P 500's.

Multi-Factor Advantages

Many evaluations and criticisms of smart beta focus on single factor approaches, which usually result in comparisons such as the S&P 500 Growth Index against the S&P 500 and so fourth. These comparisons have been relevant because many of the largest smart beta ETFs are single factor funds, meaning they focus on just one factor, such as growth or value.

However, there are well-documented flaws in single-factor strategies and that is opening the door to increasing adoption of multi-factor ETFs.

“Smart beta strategies aim to improve returns, reduce risks and enhance diversification. Yet, while exposure to certain factors has been historically rewarded over the long term, factors are not immune to changes throughout the market cycle. The return of any individual factor may be positive or negative in a particular month or year,” according to BlackRock.

Multi-factor ETFs can further reduce risk by removing the need for investors to attempt factor timing. Data suggest advisors and investors are increasingly comfortable using multi-factor ETFs as this universe has witnessed exponential growth over just the past three years.

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