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.”

 

Living In Harmony
As the debate continues, Davidow and others point toward the peace table by stressing that smart beta, market-cap indexing and active management can live in harmony by complementing one another. “With market-cap weighting, you’re going to get something that is cost effective and predictable. Fundamental weighting allows you to capture excess return. And active management through a mutual fund or separately managed account can provide downside protection over time.”

Investors can tailor the balance of the three to a particular market. In less-efficient markets where active management can help avoid danger spots, such as emerging markets, Schwab’s investment models use a mix of 50% active, 30% fundamental and 20% market cap. In the more predictable large-cap space, the firm suggests a 50% allocation to fundamental strategies, 30% to market-cap weighting and 20% to active.

Cecutto says institutional investors are both replacing active and passive management with smart beta strategies or adding them to the mix. One area where his firm sees a lot of interest is in alternative investments with high active management costs, such as real estate or hedging strategies. Nonetheless, he says, ETF investors remain at a disadvantage to institutional investors when it comes to cost. “Smart beta investment management for an institutional investor might cost 15 or 20 basis points,” he says. “If an individual is paying much more than that it becomes less effective.”

Matthew Tuttle, president of Tuttle Tactical Management, has been using smart beta ETFs to complement core positions in some client portfolios. “They’re not the best thing since sliced bread, as some of their sponsors seem to claim,” he observes. “But they are a different way of looking at things.”

One ETF in his arsenal is Guggenheim S&P 500 Equal Weight (RSP), which he uses as a core holding or as a complement to a market-cap-weighted ETF that follows the same index. He’s also replaced a traditional large-cap value ETF with Guggenheim Pure Value (RPV), citing better performance and lower volatility. And he occasionally uses RevenueShares Large Cap (RWL), although he has concerns about the relatively few shares that trade hands.
He cautions that adding smart beta indexes to the mix takes some explaining to clients, who typically view well-known benchmarks such as the S&P 500 or Dow Jones Industrial average as the yardsticks by which they gauge an advisor’s investment management prowess.

“Whenever we use an index that’s constructed differently than a traditional market-cap-weighted index, we are careful to explain the reasons behind any difference in performance,” says Tuttle. 

Smart Beta Primer
     Smart beta etfs cover a broad range of strategies. here are four popular ones:
     Fundamental. These filtering strategies assign stock rankings based on a variety of fundamental factors such as earnings, dividends, book value or revenue. The strategies these fundamental indexes use usually produce a “value tilt” relative to market-cap-weighted indexes, a characteristic some observers believe is largely responsible for their outperformance against market-cap-weighted indexes.
     Players in this space include PowerShares, which offers a suite of fundamental index ETFs developed by Robert Arnott and his firm Research Affiliates. The indexes base weightings on five-year averages of measures such as sales, cash flow, book value and dividends. WisdomTree, another fundamental indexer, focuses on dividends or earnings to determine a stock’s weighting. Its Japan Hedged Equity (DXJ) ETF is one of the largest in the industry.
     Equal weight. As their name implies, equal-weighted indexes give each component stock in an index approximately equal space. By decoupling the link between market-capitalization and portfolio weighting, they avoid housing a large percentage of assets in securities that investors are piling into at a particular time. The method gives no consideration to fundamental factors such as earnings growth, dividends or volatility. Popular ETFs that use the strategy include the First Trust Nasdaq-100 Equal Weighted fund (QQEW) and the Guggenheim S&P 500 Equal Weight fund (RSP). The former is relatively insulated from the so-called “Apple effect” that has impacted the cap-weighted Nasdaq 100 and other tech-heavy indices, while the latter gives its benchmark namesake a mid-cap and value tilt. PowerShares is also a major player in this space.
     Low volatility. Minimum-volatility ETFs are designed to create portfolios with the lowest expected future volatility. Some of them do it by using futures contracts tied to the CBOE Market Volatility Index (VIX), a popular indicator of stock market volatility. Others seek to tame the volatility beast through portfolios of stocks with low-volatility characteristics. The largest member of the latter group, the PowerShares S&P Low Volatility Portfolio (SPLV), tracks the 100 stocks in the S&P 500 that have had the lowest volatility in the last year.
     Factor-based. This approach “tilts” portfolios toward certain investment attributes, such as value, growth or momentum (stocks that have performed well recently). Examples of factor-based ETFs include the iShares Russell 1000 Growth fund (IWF) and Vanguard Value (VTV).