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Smart-Beta ETFs: Offering Headway or Hype?

We have written in the past about new trends in the ETF marketplace and one of those trends is the emerging popularity of “smart-beta ETFs.” Smart-beta ETFs weight holdings by factors other than market cap—factors such as dividends or earnings—in an attempt to produce superior long-term results. According to the July, 2015 issue of ETF Report, 34 smart-beta ETFs have come to market in 2015, or approximately 1 out of every 3 new ETFs. Equally impressive is the amount of assets gathered by the smart-beta space in 2015—nearly $40 billion as of May 31, 2015, according to financial data/analysis firm FactSet. With such a strong presence in the market, tracking the smart-beta space can be very telling about how investors may shape their portfolios going forward. It’s important to consider what is driving the demand for smart-beta products, where we are seeing the most growth, and what the critics are saying about this trend.

Smart-Beta ETFs Growing in Popularity

The demand for ETFs that utilize non-market-cap weighted strategies may be the result of a growing concern that cap-weighted indexes don't always present the perfect product from a diversification and risk perspective. Indexes such as the S&P 500 weren't created as investment products; they were created as market indicators and broad measures of stock performance. However, now that index investing has become so popular, there may be a need for more research and deeper analysis of various indexing methods.[1]

Some smart-beta strategies have gathered more assets than others in 2015. Currency-hedged ETFs have remained in high demand, along with ETFs that track momentum. There has also been growth in the low volatility and deep value spaces.[2] If we glance at some of those 34 new smart-beta ETFs that debuted this year, we see a similar focus on strategies that track low volatility and momentum-based stock selection. The low volatility focus may be of particular interest because if indexers can find a broad strategy that consistently outperforms the S&P 500—and does so with lower volatility—that could have a broad appeal among both retail and institutional investors.

Criticisms of Smart-Beta ETFs

So what are the critics saying? As with any product that is relatively new and has somewhat scattered back testing, it's hard to determine with certainty that one indexing method is better than another. We know that broad market-cap indexes such as the S&P 500 have worked in terms of producing returns that have, on average, beaten active mutual fund managers over the past 6 years.[3] What is less clear is whether or not utilizing indexes that employ alternative strategies (such as equal weighting or low volatility) will produce better returns going forward.

Some critics argue that smart-beta ETFs are trying to get their slice of the enormous ETF market by ramping up risk. An indexing method such as equal-weighting ultimately increases an investor's exposure to smaller capitalized stocks, which has historically resulted in higher volatility. In a bull market such as the one we're in, these results may be great. However, as Forbes has pointed out,[4]  if you back test well before these products rolled out, you have long periods of underperformance.

Smart-beta products may also involve somewhat higher costs than market-cap weighted products. This is due to the active component involved. These costs may still be relatively low when compared to actively managed mutual funds, but any added cost should be a consideration as it creates a hurdle for long-term performance.

The jury is still out on whether smart-beta is a trend for speculators, or if it deserves a much larger allocation within one's portfolio. The incoming flow of data over the coming months and years, and over varying market conditions, should provide some needed clarity on the utility of these products. In the meantime, investors can continue to focus on keeping their costs low and staying broadly diversified in an effort to grow their portfolios over time.

[1] Devlin, Timothy: The Benefits of a Blended Approach: ETF Report, July 2015.

[2] Murphy, Cinthia: 5 Most Popular Smart Beta ETFs This Year: ETF.com, June, 2015.

[3] Marte, Jonnelle: Do Any Mutual Funds Ever Beat the Market? www.washingtonpost.com, March, 2015.

[4] Ferri, Rick: The Dark Side of Smart Beta: www.forbes.com, January, 2014

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