Market Instinct

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Don’t Play in The Street

How Smart is “Smart Beta” Investing…

buy sell

“Smart beta,” also known as strategic, advanced, alternative-weighted, factor-based or non-market-cap weighted beta, is all the rage on Wall Street these days.  Although a broad category, “smart beta” investing is typically defined as passively following an index in which stock weights are not proportional to their market capitalization, but instead based on some alternative weighting scheme.

An example: The SPDR S&P 500 ETF Trust (SPY), the world’s largest ETF, is weighted by market cap.  Like the S&P 500 Index that it’s based on, SPY allocates its holdings to each stock based on the size of each company.  “Smart beta” says you can outperform a market-cap-weighted index if you select and weight the stocks by metrics such as dividends, volatility, revenue or momentum.

The concept has actually been around a little over a decade.  In 2003, PowerShares Capital Management introduced two new ETFs, the Dynamic Market Portfolio and the Dynamic OTC Portfolio, which (still today) use quantitative models to weight constituents using a modified, equal-weighting methodology.  This was considered by many as a significant turning point, as it was the first time an actively managed strategy, replicated through an index methodology, was available to investors through an ETF.

Since 2003, the “smart beta” category has gained popularity.  As of August 2014, “smart beta” ETF assets are up to $350 billion, a 30% increase in the past 12 months, according to Morningstar.  It is easy to understand the increase in acceptance.  The main selling point for “smart beta” is that it offers some of the advantages of an actively managed portfolio, without the fees charged by active managers.  According to Ben Johnson, director of passive funds research at Morningstar, “It’s the child of an active and passive parent.”

Are you sold?  Does “smart beta” sound too good to be true (nearly active management with nearly passive prices)? Not so fast! There are risks involved.

For starters, these so-called active portfolio managers may know little or nothing about the actual holdings within the ETF.  In addition, the holdings are predetermined by the underlying index.  Although the weights may be different (generally determined by a quantitative formula), the investor may have to hold undesirable allocations.  Furthermore, “smart beta” indices are often based on back-tests, which only go back ten to fifteen years. Investors should properly understand the behavior of a smart index in different environments.  We would typically recommend analyzing potential investments over long historical periods, covering multiple economic cycles, but that is not possible due to the fact these products have not been around that long.  Fabio Cecutto, a senior consultant at Towers Watson Investment Services, believes there is yet another risk to consider, “With nearly 370 ‘smart beta’ products on the market, there’s also the risk that the quality will begin to suffer…not all of these smart beta products are going to be well conceived.”

One more thing to ponder… I find it interesting that the term “smart beta” has only been introduced to the market in the last five years or so. The marketing lingo seems to correspond with the release of another term, “closet indexing.”  What a coincidence! I believe “smart beta” is basically a marketing gimmick, to push marginally more expensive products that customers can basically get elsewhere for less. To learn more about “closet indexing” feel free to read Don’t Play in The Street: Sometimes You Don’t Get What You Pay For.

All investments are subject to risk, including the possible loss of the money you invest. Past performance does not guarantee future results. There is no guarantee that any particular asset allocation, or mix of funds, or any particular mutual fund, will meet your investment objectives or provide you with a given level of income.

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