The rise of index funds, and the low-cost price wars, has changed much of the financial industry. The days of high cost active funds are dwindling. But if the financial industry is good at anything, its finding a way to reinvent itself, at the expense of your wallet.
Introducing Smart Beta – the newest iteration of index funds and ETFs that try to push the boundaries of performance. Some succeed, others won’t, but collectively, these smart beta funds make up a range of strategies.
In other words, you have more fund choices, with a range of differences, some more confusing than before, and more are coming. This guide is meant as a starting point to learning more about smart beta ETFs, how it works, and what you should know before buying the hype.
Table of Contents
- Intro to Smart Beta
- How Traditional Index Funds Work
- How Smart Beta is Different
- Different Smart Beta Strategies
- How it Fits in Your Portfolio
- Is it Really Smarter?
Intro to Smart Beta
Smart beta is a fancy marketing term that lumps several fund types and investing strategies together – alternative beta, strategic beta, alternative weighting, and factor-based investing – and slaps it all with the same sticker.
As you’ll later learn, these strategies use a rules based method of investing in a way that might outperform your typical index fund.
How Traditional Index Funds Work
Before smart beta came around, you had two basic ways to invest – active or passive. The active approach has you or a mutual fund manager picking stocks or bonds based on various investing strategies.
The passive approach picks index funds based on an asset allocation. Neither is perfect, but when you compare the two – index funds proved to beat most (but not all) active mutual funds for a few reasons, lower costs being a big one.
The typical index fund is built to mirror an index. For instance, an S&P 500 fund would be built like the S&P 500. The fund would own the 500 stocks in the index and would be weighted like the index.
Most indexes use a market cap weighting. The stock with the biggest market cap gets the highest weighting in the index. The second biggest market cap stock gets the second highest weighting, on down to the smallest stock in the index. But a cap weighted index has benefits and flaws:
Benefits
- Tax efficient
- Low cost
- Simple way to invest
Flaws
- Biased toward larger cap stocks
- Buys high – index buys a stock as prices rise
- Sells low – index sells a stock as prices fall
The buy high/sell low rebalancing flaw of market cap weighting is the main argument used against it. Smart beta tries to capture those benefits while fixing the flaws.
How Smart Beta is Different
Smart beta bridges the gap between active and passive. It offers a lower cost investing strategy then a managed mutual fund while being an index-based investment. But its different from the typical index fund.
Essentially, you take an active approach to choosing the rules. But once set, the rules passively invest the index. The point is to build an ETF that changes the risks and potential returns of the initial index.
For instance, a smart beta ETF would take the same S&P 500 index, own the same stocks, but weight those stocks differently. To confuse things, another smart beta ETF might change the weighting method and filter out part of the index to build a fund around a specific investing strategy. The common thread is that smart funds don’t use market cap weighting.
By not using a market cap weighting, these funds can rebalance more efficiently. Rather than buy more of an overpriced stock, a non cap weighted fund sells a stock as its price rises and buys more as its price falls.
Risks and Returns
By tweaking an index fund, you can adjust the risks and returns until you find the right set of rules to build an investing strategy around. You can build a smart beta ETF that lowers the risk or performs better than a plain vanilla index fund.
Of course, that’s the selling point – who doesn’t want less risk and higher returns? It allows fund companies to build new funds that advertise more safety or performance while charging a higher fee. But changing an index brings real risks, beyond higher costs, when not tested thoroughly.
Backtesting
Rather than having a fund manager actively hand-pick stocks, backtesting takes all the stocks in an index(sometimes it filters some out) and shuffles them up.
Think of it like a deck of cards. Backtesting lets you shuffle a deck of cards, play out the hand, record the results, and do it millions of times until a favorable “shuffle” emerges. In essence, backtesting lets the fund company try to stack a deck of stocks in a way that outperforms the index. Or, at least, find out how a stacked deck of stocks performs against an index.
Keep in mind, all of this is done after the fact based on historical data. All you know is that it worked in the past. There’s no guarantee it works going forward. Given enough time, even I can make up a strategy that worked great over the past ten years. Consider this before jumping into a fund:
- Was this fund backtested?
- How was it tested?
- How far back was it tested?
- When did the strategy go live?
- Have changes been made since it went live?
Not all backtesting is bogus. Make sure testing was done using data through different economic periods. It’s important to educate yourself about the fund first, the factors being used, and how it works.
Ask yourself – why does it fit your investment plan better than a plain vanilla index fund or other smart beta fund? If you’re only answer is “It performed better last year”, it’s not a good fit.
Different Smart Beta Strategies
The different smart beta strategies are built around backtested research. Once a favorable shuffle is found, a fund is built based specific rules that match those characteristics.
The early funds were built on simple rules that only changed the weighting of the index. That evolved to more complex rules that combined other factors along with an alternative weighting.
Alternative Weighting
Early research showed that different weighting methods would change how an index performed:
- Equal Weighted – all stocks in the index are owned equally and contribute equally to its performance. An equal weighted index tends to outperform its cap weighted counterpart.
- Fundamentally Weighted – weighting is based on one or more fundamental factors like sales, book value, cash flow, or earnings. Stocks that meet those factors are weighted higher than those that don’t. This also tends to outperform its cap weighted counterpart.
But why do these weighting methods perform better over longer periods?
Equal weighting works by accident. If I rebuild a S&P 500 fund but weight it alphabetically, it would outperform the cap weighted fund. It’s not because companies that start with the letter A do better. By accident, all I did was tilt the fund toward factors that tend to outperform the market over longer periods.
An equal weighted index removes the large cap bias of a market cap weighted index (small caps make up a larger part of the fund) along with the flawed rebalancing rules (it buys low and sells high).
There’s no accident with fundamentally weighted funds. These funds are built specifically to take advantage of the factors that outperform the market over time.
Factor Investing
The one constant with academic research is the tireless pursuit to explain outperformance. What’s been found is that stocks that meet certain criteria do better than the market over longer periods.
Keep in mind it’s not a perfect science – they don’t outperform all the time. An argument can be made for these six factors:
- Value – undervalued stocks outperform the market – some metrics used to measure value are P/E, P/S, P/B, book value.
- Size – smaller cap stocks outperform larger cap stocks.
- Momentum – stocks that outperform continue to outperform in the short-term, those that underperform continue to do so in the short-term.
- Volatility – less volatile stocks outperform the market – metrics used are standard deviation or beta.
- Yield – stocks with higher dividend yields outperform the market. Reinvested dividends boost performance further. I’d include shareholder yield (dividend, stock buybacks, and paying down debt) here too.
- Quality – stocks of higher quality companies outperform the market – some metrics used are ROE, profit stability, low debt, consistent earnings growth, cash flows. Quality factors work best in combination with another factor, like value.
Factor investing takes this research a step further by singling out the reason for the better long-term performance. If you built a factor-based ETF, you would start with a market cap index, but whittle it down to only those stocks that qualify, then weight it equally or fundamentally, and build a fund around it.
For instance, with a dividend ETF, you only include stocks that pay a dividend. Other factor-based ETFs simply drop the dead weight – why own every stock, both good and bad, when a factor filters out the latter. Sometimes the best way to stack the deck is to remove the worst cards.
Multi Factor Investing
Multi-factor is a strategy built around the childlike philosophy that if one is good, two must be better. The investing strategy combines two or more factors, like value, quality, and yield, and builds a rules based fund around it.
The reason it works is because these factors don’t work all the time. Factors are cyclical – one will beat the market for a some time, then fall short for a period, but research shows the long-term potential. The hard part is knowing where each factor sits in the cycle and when it will turn.
Also, some factors work at the same time (high correlation), others don’t (low correlation). By combining different factors that work with and against each other you increase returns and lower risk.
Obviously, multi-factor investing gets more complicated as more factors are added. Expect the cost to increase too. It requires a better understanding of how each of the factors work. But with the right combinations, you could further lower risk or increase returns.
How it Fits in Your Portfolio
If you have an allocation of 40% U.S. stocks, 20% international stocks, 10% emerging market, and 30% bonds, there are several ways to adjust your risks and expected returns:
- You can change your allocation – like move money from U.S. stocks into international stocks or into bonds.
- You can tilt your allocation toward one or two factors – like adding value or small cap funds.
- You take a slight active approach – diversify across risk factors – value, momentum, volatility, and size.
The third choice was only available at a higher cost compared to the first two. Those costs are coming down due to new smart beta funds and will continue to fall as competition increases.
Instead of diversifying across a specific asset allocation, you can choose low-cost funds to diversify across several risks. The rules based method of these fund naturally picks up different asset classes while staying focused on risk, rebalances toward lower risk/higher returns, while selling high and buying low.
Is It Really Smarter?
The biggest argument against smart beta is that it tilts an index toward value or small cap which has shown to outperform the market over longer periods. Yes, the alternative weighting methods do this either by accident or on purpose.
Value and small cap funds have been around forever and cost less than these smart beta funds. Why pay more for what amounts to the same thing? I made this point before with low volatility funds, showing how to find lower cost ETFs that have the same effect.
Keeping your costs low will always be important. You need to decide if the tradeoff for lower risk and potential higher returns is worth paying a higher expense ratio.
However, factor investing offers some unique opportunities. I’d rather see a smart beta ETF focused on value while avoiding expensive stocks then one only focused on value. What’s the point of buying a value fund if it owns the cheapest expensive stocks? Even expensive value stocks can’t outperform forever – eventually all expensive stocks fall in price.
Sure, some smart beta funds have a fancy name that recreate a value fund for a higher fee. Some might improve on it. Others will be worse. Skepticism, education, and research will help you pick out the imitators from the real deal.
Know that none of these strategies work 100% of the time. Don’t expect to find the holy grail of investing buried in a smart beta ETF somewhere. If you do, eventually everyone will buy it till it no longer works, underperforms, goes out of favor, and starts the cycle anew. The only way you benefit is to time the cycles perfectly (good luck) or have the discipline to do nothing when the cycle turns.
