A flood of money has rushed in recent years into smart beta ETFs and other funds, which now hold a total of $800 billion in assets globally as of yearend 2018, according to Morningstar data. Financial advisors and investors have increasingly favored this factor-weighted investing strategy because it has outperformed despite its higher fees, as outlined in a detailed story in the Financial Times.

Smart Beta's Next Big Challenge

These smart beta ETFs, which have thrived during the lengthy bull market, may get their ultimate test if a protracted U.S.-China trade war, weak corporate earnings and other forces push the broader market into a sustained decline. But Shawn Parker, an adviser at Ameriprise Financial, isn't worried. “We have found that, even if you’re paying slightly more [in management charges] for a smart beta ETF, the performance has been stellar, both on the upside, because of maybe some momentum advantage, and also on the downside, because of maybe a low volatility advantage,” Parker told the FT. “So we’re encouraged by the results.”

Smart beta assets make up about a third of the funds Parker has under management, nearly four times the average 7 percent of client funds in the 2019 FT 400 listing.

Factor Investing On the Rise

  • Smart beta ETFs take a basic index and modify it based on factors designed to outperform the market
  • Assets in smart-beta ETFs have grown 30% annually since 2012
  • Smart beta funds accounted for roughly $800 billion in AUM in 2018
  • Financial advisers allocate an average of 7% of clients’ AUM in smart beta funds

Source: Financial Times, Barron’s

Higher Fees 'Well Worth It,' Volatility Risks

This investing strategy is a mix between passive and active investing, wherein smart beta exchange traded funds take a basic index and modify it based on factors designed to outperform the broader market, per the FT.

For clients who are new to smart beta ETFs, especially those who have dealt primarily with mutual funds, Parker says there is a “learning curve” in educating them. Fees are higher compared to standard index-tracking ETFs, but they have been “well worth it,” she says.

Despite their rising popularity and above average performance, not all are so upbeat on smart beta ETFs, including Rob Arnott, founder and chair of Research Affiliates, a pioneer in smart beta investing. Arnott told the FT that smart beta could go “horribly wrong” as a flood of investors chasing performance could lead to a “smart beta crash.”

Looking Ahead

To be sure, the luster around smart beta ETFs may be fading after a 30% annual increase in assets every year since 2012, according to Boston Consulting Group, as cited by Barron’s. Some of the biggest firms are pruning smart beta funds from their offerings. Financial giant State Street Advisors, for example, recently changed how its new indexes are weighted, changing from factor-based investing to traditional stock market capitalization.