Analyzing graph trends © robertlamphoto/Shutterstock.com

Smart beta funds are the new black. Just one question: What does “smart beta” mean?

Trying to round up all the strategies that fall under the smart beta umbrella is a little bit like trying to herd cats. They’re all over the place, each with different notions on where to go and how to get there.

Even the name is up in the air. Yet, despite the disorder, smart beta may be more than marketing hype.

Uniting characteristics

Smart beta funds — also called strategic beta, alternative beta or advanced beta — do have a common thread. They are basically index funds, but they differ from the usual index funds that are weighted by the market capitalizations of the companies that make up the index. Instead, the companies in the index are arranged by something other than size.

Here’s another way of putting it: They are all passive funds making an active bet, according to Alex Bryan, analyst on the passive strategies team in manager research at Morningstar.com.

An extremely brief history of the market-cap weighted index

Indexes such as the Standard & Poor’s 500 index or the Russell 2000 are weighted by the market capitalization of the companies in their respective index. The bigger the company, the more weight it gets in the roster.

“This is just arithmetic. Why did there develop such an interest in these cap-weighted indices?” asks Marc Reinganum, Ph.D., senior managing director and chief quantitative strategist at State Street Global Advisors.

Back in the mid-20th century, a couple of academic ideas, including the Sharpe ratio, a measure of risk and return, stated that there was an optimal portfolio that would maximize returns for a given level of risk. “This market portfolio, this cap-weighted portfolio, maximizes the Sharpe ratio,” says Reinganum.

The 1980s and 1990s happened to be a good time to be a very big company.

“It was a good environment for all equities, but especially for large-cap equities. That means it was good for indices that give heavy weight to large companies, that give weight in proportion to the size of the company,” he says.

Though passive investing has turned out to be pretty great, some people thought it could be improved and endeavored to build a better passive fund.

See-through strategies

As with index funds, the strategies that smart beta funds use should be out in the open. Typically they are less proprietary and research-driven than strategies used by a purely active fund. But they’re still slightly more active than a passive fund.

“The way I see smart beta funds, they are meant to be low-cost, index-like, lower-turnover funds. They are an effective way of capturing better exposure to the equity market. I would tell (investors) to largely ignore the more complex, expensive options that promise too much,” says Jason Hsu, co-founder and vice chairman of Research Affiliates, a pioneer in fundamental index strategies.

With no unifying way of weighting stocks, they can be weighted in any number of ways, depending on their objective.

Morningstar’s taxonomy groups the funds by strategy, or what they are trying to accomplish.

“You have everything from dividend strategies to fundamentally weighted strategies, momentum strategies and quality strategies,” Morningstar’s Bryan says.

“Despite the wide array of different strategies that these funds cover, it really boils down to several factors: overweighting value stocks, stocks that are cheap; maybe overweighting small-cap stocks; or they may be overweighting quality stocks. Those are the three main tilts that these funds take, at least on the equity side,” Bryan says.

Strategic beta fund performance

So how do these strategic beta funds fare against the market-cap weighted S&P 500? The accompanying chart shows that over three and five years, these funds underperformed that benchmark, but over 10 years, smart beta ETFs show a slight edge. Note that the ETFs are considerably cheaper than their mutual fund counterparts.

Smart beta funds vs. S&P 500

Name 3-year annualized total return 5-year annualized total return 10-year annualized total return Net expense ratio
Strategic beta ETFs* 3-year annualized total return: 13.33% 5-year annualized total return: 12.5% 10-year annualized total return: 7.9% Net expense ratio: 0.48%
Strategic beta mutual funds** 3-year annualized total return: 18.17% 5-year annualized total return: 13.69% 10-year annualized total return: 6.98% Net expense ratio: 1.17%
S&P 500 index 3-year annualized total return: 20.42% 5-year annualized total return: 15.45% 10-year annualized total return: 7.67% Net expense ratio:  

Source: Morningstar. Returns are through Dec. 31, 2014.

*Results from 394 strategic beta exchange-traded funds covered by Morningstar.

**Results from 43 strategic beta open-end mutual funds covered by Morningstar.

The table doesn’t tell the whole story, though. For instance, not all mutual funds are pricey. Expense ratios for the smart beta funds range from 0.06 percent to nearly 2.3 percent.

And performance varies widely among the funds. For example, over three years, the S&P 500 delivered a 20 percent return on average. Among the smart beta ETFs, returns ranged from negative 20 percent (for a commodities fund focused on silver) to a whopping 42 percent gain (for an equal-weighted S&P Biotech ETF). Over five years, the S&P 500 returned 15.5 percent on average, while ETF returns ranged from 31 percent (for a health care fund) to negative 10 percent (for an oil-oriented commodities fund).

Do’s and don’ts

There’s a proliferation of smart beta funds and a finite number of ideas. That means there’s a lot of overlap among mutual funds. How can an investor choose?

  • Do pay attention to the expense ratio. “A lot of times, you could find this really nifty-sounding strategy that charges 50 or 60 basis points when essentially all you are getting is a value tilt or a small-cap tilt. And investors could, a lot of times, get that more cheaply through a market-cap weighted value or small-cap fund,” Bryan says.
  • Don’t be dazzled by past returns or historical simulations. “If you look at where the money goes, it goes into the funds that have had the best recent performance,” says Bryan. “Take a step back and make sure that the strategy makes sense going forward.”

    Plus, the oldest smart beta funds are only about 10 years old. New funds are trotted out all the time with simulated records showing how they would have performed in the past. These theoretical simulations are known as “back tests.”

    “There’s really no such thing as a bad-looking back test, because if it had a bad-looking back test, the provider would have gone back to the drawing board. So we encourage people to discount back-test results,” Bryan says. Instead, investors should look at the fees they are paying, he adds.

  • Do understand what you’re getting. Smart beta funds are a little more expensive than index funds, and they’re a little more complicated. Piling on layers of complexity may not improve returns.

    “There is a lot of data out there on securities. Computational power is cheap, and it’s easy to find a computer and a database and crank out numbers,” says Bhanu Singh, a vice president and portfolio manager at Dimensional Fund Advisors.

    Dimensional Fund Advisors doesn’t produce smart beta funds, but it does focus on capturing premiums such as size, value and profitability in its fund offerings.

    “Investors have to do their homework and be careful about the purported source of extra return. All these strategies have various ways of saying, ‘This is where our return comes from,’ but you have to make sure that it’s actually a reliable result, that it makes sense and is likely to be there in the future rather than something that is likely to be spurious or data-mined,” Singh says.

    Whatever factor or characteristic the fund utilizes should persist across time and countries — such as the factors identified by Eugene Fama and Kenneth French and other researchers. They found that the factors that explain much of the returns of all stocks are the size of the company, value and profitability.

    “We see size, value and profitability premiums in U.S. markets, in European markets, in developed countries and also in emerging markets. These are quite pervasive across a lot of markets. So that gives you a lot of comfort in the fact that there is something going on rather than just a data fluke,” Singh says.

    As with most other investments, keeping a skeptical mind and an eye on cost can help investors discern the marketing hype from solid investments.

Promoted Stories