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Can These Hot Passive ETFs Keep Topping the Benchmarks?

NEW YORK ( TheStreet) -- Stocks have provided rich rewards since the financial crisis. During the past five years, SPDR S&P 500 (SPY) returned 16.5% annually, according to Morningstar. But you could have done even better with ETFs that weight stocks in less traditional ways. Guggenheim S&P 500 Equal Weight (RSP) returned 19.9%, and PowerShares FTSE RAFI US 1000 (PRF), which weights stocks according to fundamental measures, returned 19.6%. Other promising approaches include funds that emphasize stocks with low-volatility or momentum. Often called smart beta benchmarks, the alternative approaches have come to be seen as ways to outdo the traditional measures such as the S&P 500.

Among the leading proponents of smart beta strategies is Rob Arnott, chairman of Research Affiliates, the developer of the RAFI benchmarks. In recent research, Arnott looked at how half a dozen smart beta strategies would have performed over the last 50 years. All the strategies topped traditional benchmarks. The high-volatility approach outdid the S&P 500 by two percentage points annually. Low volatility fared even better.
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Arnott concluded that the traditional benchmarks trail because they weight stocks according to market capitalization. Under that weighting system, Apple (AAPL) -- the biggest stock in the S&P 500 -- accounts for 2.8% of the assets in the index, while Abercrombie & Fitch (ANF) accounts for 0.03. When a hot stock rises, it will account for a bigger weighting in the S&P 500. "The notion of giving more weight to rising stocks seems to be wrong," Arnott said, speaking at the recent Morningstar ETF Invest Conference in Chicago.

The hazards of market-cap weighting became clear during the bull market of the late 1990s as technology stocks soared and dominated the benchmark. After the Internet stocks collapsed in 2000, S&P 500 index funds sank hard. Arnott claims that smart beta benchmarks deliver better results because they don't keep piling assets into the hottest stocks. Instead, the alternative strategies weight stocks by measures such as sales or volatility, which don't always rise and fall with stock prices.

But not everyone has been persuaded by the recent winning streaks of some smart beta funds. Vanguard Group, which has long championed traditional index funds, argues that market-cap weighting represents the best approach for passive investors. According to the Vanguard view, the prices of stocks represent their fair values at any given time. Smart beta systems are engaging in a form of active management, betting that some stocks are undervalued. While smart beta funds have excelled during some years, at other times the approaches have lagged for long periods.
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