Faced with an increasingly competitive landscape, ETF providers are differentiating themselves by promoting the potential for better returns through rules-based indexing strategies other than market capitalization, the traditional ranking gauge. Judging from an onslaught of ads and new product launches, the resulting marketing juggernaut, called smart beta, could transform the low-cost, simple world of passive index ETFs into something vastly different.

According to Morningstar, over 18% of the $1.7 trillion ETF universe is devoted to strategies the firm classifies as smart beta, which include strategies such as fundamental weighting, equal weighting and low volatility. Institutional investors are also embracing such strategies according to consulting firm Towers Watson & Co., which reports that such clients made about $11 billion in investments linked to smart beta in 2013, compared with about $5 billion the year before.

“There is documented evidence that the market premium smart beta produces can be accessed and exploited on a consistent basis, without the high cost of active management,” says Fabio Cecutto, head of international equity manager research at consulting firm Towers Watson. “Our institutional investor clients are seeing the benefit of adding a new element to portfolio structure while keeping costs down.”

The ascendance of smart beta products has led to a growing debate among indexers about the merits of old-school market-cap-weighted strategies versus the newcomers. Smart beta ETF sponsors cite back-testing and trading history to support claims that their own variations of the smart beta theme have outperformed market-cap-weighted indexes over most time periods. Market-cap weighting is flawed, they say, because it overemphasizes popular, hot stocks and gives too much real estate to a handful of securities that drive returns. Marketing literature for smart beta ETFs often stresses avoidance of market “fads” inherent in market-cap weighting in favor of neglected or underpriced companies.

But fans of market-cap weighting contend these newcomers are nothing more than old strategies dressed up in new, more expensive clothing. Because smart beta ETFs usually require more frequent rebalancing and have higher turnover, their expense ratios can be as much as four or five times higher than comparable market-cap-weighted ETFs. In terms of annual expenses, they typically fall somewhere between market-cap-weighted index ETFs and actively managed mutual funds.

Illiquidity is another concern. With so many new smart beta ETFs available, many of them have yet to find a substantial audience, so their shares don’t trade hands much. That’s a concern for many investors, especially those who aren’t used to buying or selling thinly traded securities.

With so many new products coming out, it’s getting hard to distinguish which ones are actually worth investing in. Since many of these ETFs are so new, they rely on back testing of their indexing methodologies to lend credibility to claims that their strategies “beat the market.” But in some cases these tests go back only 10 years, which doesn’t reveal how benchmarks would fare under longer historical cycles. And in the real world, ETF performance will differ from that of a benchmark index because of expenses and trading issues.

None of these issues would be deal breakers if claims of superior performance are indeed true. But market-cap enthusiasts believe that many of the investment tilts smart beta strategies produce as a byproduct, such as a growth, value or small-cap orientation, explain why they outperform. In many cases, they say, these tilts can be replicated by adding lower-cost market-cap-weighted ETFs with those labels to the investment mix.

Smart beta ETF sponsors like Vince Lowry, founder and president of RevenueShares, challenge that contention. “It’s not a size or value bias that wins out,” says Lowry, whose firm ranks and weights stocks in indexes according to revenue. “It’s the superiority of an indexing system based on revenues.” He adds that while many of the ETFs are thinly traded, investors can work around that hurdle by stipulating prices at which they want to buy or sell in trading orders.
Others believe the trade-off between higher costs and stronger returns is worth it. “Fundamental indexing has shown pretty consistent excess returns relative to market-cap weighting and actively managed funds,” says Tony Davidow, vice president at Charles Schwab, which offers its own branded suite of market-cap-weighted and fundamentally weighted ETFs. “We believe 200 basis points in excess return is a good trade-off for a slightly higher cost structure.”