“Smart beta” ETFs are set to upend traditional asset management, attracting assets from both active managers and passive indexes.

David Koenig, investment strategist at Russell Investments, which has created widely used smart beta indexes, explains: “Smart beta sits right in the middle of what has been considered beta and what has been considered alpha. Part of what had been attributed to manager skill can be accounted for by exposure to certain factors.” These include company size, stock price momentum and price to book value ratios that computers can efficiently discern.

Smart beta ETFs can do three things for investors: 1) more precisely target the type of exposure an investor would like; 2) dynamically rebalance the portfolio, usually quarterly, based on changes in price and certain pre-determined fundamental criteria without the tax consequences of a high turnover strategy; and 3) allow for daily trading, full disclosure of holdings and relatively low fees.

If Webster’s definition of smart—“very good at learning or thinking about things; showing intelligence or good judgment” —truly applied to smart beta funds, the investment advisory business could pack up and go home. Actually, these computer-driven index funds could create more demand for professional advice on positioning smart beta funds in portfolios—that’s where the real “smarts” come in.

“Nuance is important,” says Morningstar passive strategies analyst Alex Bryan. “You need to understand what the fund is really doing. You have to do your homework.” Morningstar does not rate smart beta funds because they are ETFs, but it publishes research on a number of them.

The ETF structure has played a key role in the break-out of this investment category for individual investors. Computer algorithm-based investment strategies usually don’t make sense for individuals because frequent short-term trades generate unpredictable tax consequences. But the ETF structure allows for the transfer and replacement of securities within an ETF to often be counted as a tax-free exchange, making them tax efficient.


So what, exactly, is smart beta? The answer involves a brief history of academic thinking about investment performance. For a long time, people assumed that there were good investors and bad investors and that returns reflected the relative skill of the investor. But in recent decades, a lot of work went into figuring out what made one investor outperform and another underperform. Some of that work has been in behavioral finance, where emotion turns out to be an important performance factor.

But there is more than emotion at work. Computer power has enabled detailed analysis of other drivers, so-called style factors or risk factors, that influence returns. The result: Researchers have been able to tease out specific traits that improve investment performance compared with capitalization-weighted market indexes. Identifying and screening for these traits requires a lot of number crunching by carefully designed computer programs.

“I think smart beta is great,” says Alexey Malakhov, associate professor of finance at University of Arkansas, who has extensively studied hedge fund returns. “It really gives investors the opportunity to pursue strategies previously available only to hedge fund managers.”

The simplest example of smart beta, the $7 billion Guggenheim S&P 500 Equal Weight (RSP) ETF, holds all 500 stocks in the S&P large cap index, but with an equal dollar weighting to each at the start of every quarter. This fund has outperformed the cap-weighted S&P 500 index recently and was up 3.2% for the year in mid-May when the S&P 500 index was up 2.4%. By equal weighting, the fund has equal exposure to giant and large companies, and since it sells winners and buys losers each quarter to equalize positions, it may have a contrarian or value bent compared with the cap-weighted index. Because it’s an ETF, investors benefit from the quarterly rebalancing without complicated tax implications. The expense fee is 40 basis points.

An important thought leader in smart beta indexing, Research Affiliates, calculated the theoretical 10-year performance of an equal-weighted S&P 500 index (without fees) vs. the normal index for 2003-2013 (see chart). It found that annualized returns for the equal-weighted index would have been almost 40% higher than the standard index; 10.2% annually vs. 7.3%. Few active managers could claim this degree of 10-year outperformance in a fully invested long stock portfolio. Of course, there may be periods in which equal-weighted funds underperform market-cap weighted funds. All computer-driven funds are backward looking, as is performance data. But the equal-weighted fund concept can be incorporated into a market exposure, giving investors a slightly different risk profile.



“The ‘smart’ in ‘smart beta’ is the ability of the advisor to build more precise portfolios depending on the exposures they want,” says Russell Investment’s Koenig.Once beyond the equal weighted type of “smart beta” fund, life becomes more complicated. “Fundamentally weighted” indexes use criteria that analysts have long evaluated to screen for companies likely to outperform. Charles Schwab launched a suite of “fundamentally weighted” ETFs last summer, using Russell indexes based on the algorithm design work of Research Affiliates. Schwab discloses the three main criteria for screening and fees of .32% for four of its six fundamentally weighted ETFs and .46% for two international funds.

It is important to look at the portfolio holdings in every fund. “Fundamentally weighted funds can overweight financials,” says Morningstar analyst Bryan. “One of the common criticisms of fundamentally weighted funds is that they are essentially value strategies,” adds Bryan, making it especially important for advisors to consider the holdings in the context of a client’s overall portfolio.


Institutions, too, are hopping on the smart-beta bandwagon. A State Street Global Advisors survey of 300 institutional investors, “Advanced Beta Comes of Age: State Street Global Advisors Study Finds Appetite Growing Among Institutional Investors,” found growing interest among institutions in what they call “advanced beta” investing, and not just to replace passive indexes.

The report’s surprising finding was that “although advanced beta is often marketed as an alternative to cap-weighted indexing, many investors see advanced beta as a replacement for active and are three times more likely to fund an advanced beta allocation from active rather than passive.”

While good data on the size of assets in this category is scarce, it’s clear that smart beta is in its infancy. With interest growing among all investors, education will be crucial.

Prof. Malakhov sees the next phase for smart beta as one of bridging the knowledge gap between the fund providers and consumers, likening that challenge to the telecoms laying fiber optic cable from the node to the home. “What’s missing with smart beta right now is the ‘last mile,’” he says. “Communicating the advantages and risks to the advisors and the individual investors, even to the institutions.”

Indeed, State Street’s institutional survey also found that “while 70% of investors report high levels of awareness about advanced beta, only 40% are confident about implementation.”

As more esoteric strategies emerge in smart beta, the need for better analysis of the fund products is likely to grow. For instance, the ALPS U.S. Equity High Volatility Put Write Fund (HVPW; 0.95% expense fee) owns treasuries and sells put options on 20 highly volatile stocks every 60 days, aiming to pay 1.5% of assets as a dividend six times a year.  Clearly, this is a high-yielding strategy that comes with a lot of risk, but it is also the kind of strategy most individuals could never have accessed in the past.

On the other hand, PowerShares S&P 500 BuyWrite Fund (PBP; 0.75% expense fee) essentially owns the S&P 500 and writes calls against it, reinvesting the premium. This fund has naturally given up a lot of the recent upside in the stock market, but might be suitable for an investor worried that the market is extended.

“This universe will keep expanding,” says Malakhov. “Smart beta is a label for a huge universe of products that are really quite granular. Hopefully, with more education, products will be built with exactly the risk exposures each investor wants. Then, smart beta can do great things for you.”

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