While more and more money flows into index funds, active management’s bright spot over the past few years has been so-called smart beta funds. According to BlackRock, 25% of all new money flowing into stock funds found its way into smart beta funds in 2014. And according to a November 2015 article on ETF.com, smart beta ETFs took in around $52 billion or 30% of all flows into ETFs for 2015 to that point. 

Delink Size And Portfolio Weight

Smart beta strategies are considered to sit somewhere between indexing and active management. The strategies try to beat the S&P 500 by tracking a different index that doesn’t rank funds on market capitalization or sheer size. The new indexes don’t accept the market as it presents itself, with the largest stocks occupying the highest positions of rank. Therefore, smart beta funds are passive in following an index, but active in not following a “capitalization weighted” index.

Smart beta indexes are based on historical performance back tests and studies run by academics on various “factors” or characteristics of stocks. A successful back test often leads to the creation of a new index based on the factor that appeared successful in hindsight. The factors are often related to value (low price/earnings or low price/book values), dividends, size, low volatility or price momentum. 

A white paper from Research Affiliates in Newport Beach, Calif., says breaking the link between market capitalization and rank in an index or portfolio is the defining feature of smart beta strategies. Therefore, smart beta tries to exploit the defect inherent in capitalization-weighted indexing—that more popular stocks gain more prominence in the index and garner more investment dollars. Research Affiliates’ founder, Robert Arnott, is the creator of a “fundamental index” that ranks stocks on their companies’ economic footprint—sales, cash flow, dividends and book value—and has been used in the first smart beta funds such as the Pimco RAE Fundamental Plus Fund (PXTIX).

Disparity Of Short-Term Returns

The proliferation of smart beta funds might be confusing more than helping investors, so it is important to see how they’ve behaved recently. Nobody should make an investment decision on one-year’s worth of performance, but a glance at 2015 returns shows how disparate different smart beta factors can be. A factor that has worked in a back test or even in a live fund over a long period of time isn’t guaranteed to work every year or even over every market cycle.

For example, 2015 results using the iShares suite of smart beta funds show a meaningful disparity of returns between those that are value and dividend oriented and those that are growth, momentum or quality oriented. Besides the iShares suite of ETFs, the chart also includes the S&P 500, Russell 1000 Value and Russell 1000 Growth indexes, in addition to two popular mutual funds, the aforementioned Pimco fund and the DoubleLine Shiller Enhanced CAPE fund (DSEEX). 

The chart shows that three iShares dividend-focused smart beta ETFs lost between 2% and 4% in 2015. By contrast, funds organized around minimum volatility, quality and momentum factors all returned 5.5% or better for the year. It’s evident, as well, that the strategies can cluster around simple growth and value characteristics and indexes. The lagging group clustered around the Russell 1000 Value index, while the outperforming group clustered around the Russell 1000 Growth Index.

The Pimco mutual fund, which weights stocks on sales, cash flow, book value and dividends, lost more than 6% for the period. By contrast, the S&P 500 gained 1.4%. The fund weights stocks on their economic footprint rather than on an explicit value factor. That emphasis gives it a value and small size tilt relative to the S&P 500.

The DoubleLine fund is unique in that it combines an explicit value strategy with a momentum filter that has spared it the underperformance of its value-oriented brethren. (We’ll discuss this fund in greater detail later.)

Sector Risk

Investors surveying the field of smart beta funds should understand that one sector can make or break a group of funds over the short term, and that’s mostly what happened last year. One reason many dividend funds and value funds are lagging behind this year is their exposure to energy.

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