Smart beta exchange-traded funds are becoming something of a rage, these days, as proponents say they represent an alternative to traditional indexes that can trigger a welcoming "two-for" that benefit investors - the potential to outperform an industry benchmark and the ability to reduce risk.
"The combination of underperforming active mutual funds, the secular trend towards lower cost investments, and the rising popularity of the ETF structure has driven investors' growing interest in smart beta ETFs," says Nathan Geraci, at The ETF Store, Inc. in Kansas City, Mo.
Many financial advisors see such indexes as a good way to provide investment exposure to myriad investment categories, while offering portfolio transparency, and a way to leverage volatility and imbalances in the financial market, while providing a clear path portfolio diversification.
So far, investors like what they see from smart beta funds. A 2016 European study from the EDHEC-Risk Institute shows 86% of investors are satisfied with smart beta indexes, which bypass stock or sector concentration. That sentiment has helped push smart beta ETFs passed $500 billion in assets, as of January, 2017.
Yet even with that high level of satisfaction, there seems to be a significant level of uncertainty - particularly around performance gauges.
"Smart beta is an unfortunate term because it predisposes you to believe that traditional beta is not as effective or innovative as Smart beta," explains Andy Martin, and ETF expert and money manager with 7Twelve Advisors LLC in Nashville. "The data has shown that beta, itself, has outperformed 70% of active managers for the long-term, so smart beta would have to beat active managers by even more to prove their superiority. Unfortunately, there simply is not a track record currently that could prove that claim."
Martin describes smart beta ETFs as funds with various factor tilts (or preferences) to value, yield, quality, size, momentum, low-volatility, equal-weighting or some other perceived attractive investment feature. "Some describe it as anything but a market-weighted index," he says. "What's interesting to me is that the index industry is convinced that it is settled science that passive outperforms active, yet smart beta is a variant of active investing."
The Guggenheim S&P 500 Equal Weight ETF (RSP - Get Report) , which tracks the S&P 500R Equal Weight Index (EWI - Get Report) , was likely the first smart beta ETF, and even today it's the dominant sector name. "It has shown the longest track record of outperforming the S&P 500," Martin says.
For financial advisors, smart beta ETFs like RSP make a lot of sense for investors, provided fees are kept in check and the smart beta component used intelligently, says Daniel Lugasi, portfolio manager with VL Capital Management.
Lugasi says the burgeoning success of smart beta ETFs "shows the power of systematically exploiting persistent market anomalies, value and momentum being the primary factors."
"It's long been known for example that the common market cap weighting used by many indexes leads to overweight positions in more expensive stocks," Lugasi says. "Moving to things like equal weighting, which tilts more towards value, tends to outperform as a result."
The catch is that many investors conflate alpha with risk. "It's likely that while the returns of some of these products outperform benchmarks when markets are rising, they will underperform when they fall," he says.
Smart beta funds may also take some of the human element - and human-induced mistakes - out of the portfolio management equation.
"We view smart beta as the automation of active management," explains Geraci.
Geraci says that when you think about automation, it typically has the effect of reducing costs and minimizing human error and bias. "That's exactly what's happening with smart beta strategies," he says. "These ETFs utilize a rules-based approach to investing, but there is some sort of an active bet being made. You simply get that active bet at a lower price point and without the human emotion found in traditional active management."
As with active managers, perhaps the most important rule with smart beta strategies is sticking with them over full market cycles, Geraci says. "Attempting to time the different factors or exposures offered within smart beta strategies is a fool's errand," he warns.
Smart beta models may actually become so pervasive that the investing methodology may change the way ETFs are structured, says Kevin Quigg, chief strategist at ACSI Funds, in Ann Arbor, Mich.
"The growth of advanced beta is interesting both from an absolute standpoint -- these strategies account for almost $500 billion in ETF assets -- as well as what it says about the potential future growth path of the ETF industry," Quigg explains. "As the ETF marketplace has become more of a microcosm of the investing public at large, investors are seemingly moving away from the simple cap-weighted strategies that were the primary growth vehicle in the first 20 years of the industry."
The growth of advanced beta strategies is particularly noticeable among the traditional mutual fund companies who have entered the ETF marketplace, Quigg adds.
"Oppenheimer, John Hancock, Legg Mason and JP Morgan are all examples of traditional fund complexes that have entered the ETF marketplace in the past three years by introducing advanced beta offerings," he says. "The common thread between all of these managers are large, developed distribution networks within the retail brokerage marketplace and the traditional wirehouses -- like UBS, Morgan Stanley, Merrill Lynch, Wells Fargo -- in particular."
"The real question that will be answered in the future is whether advanced beta strategies are the finish line or merely a weigh station or placeholder on the path to introducing active insight into the ETF marketplace which has traditionally been filled by the active mutual funds that dominated the retail space," Quigg states.
Industry acceptance of smart beta ETFs is proof that as traditional mutual funds continue to diminish in popularity and many hedge funds struggle to justify their fees, the investing public is ready to plow more cash into the ETF industry, Quigg adds: "The growth of advanced beta along with differentiated strategies seems to be a promising sign that this industry is ready to assume a larger part of the wealth management marketplace of the future."