Baskin-Robbins
According to fund research firm Morningstar Inc., as of year-end 2014 there were 394 smart-beta––or strategic beta (its preferred term)––exchange-traded products in the U.S., with more than $402 billion in total net assets. That’s up from 352 funds with nearly $320 billion in assets the prior year, and 211 funds with $133 billion in assets in 2010. And as of the end of last year, such funds represented 20% of all U.S. ETP assets.

Smart beta’s various flavors make it a veritable Baskin-Robbins. As described in a Morningstar report on smart beta released in September, some are return-oriented strategies that seek to boost returns relative to a standard benchmark by employing size, revenue, earnings, momentum, quality (companies thought to have durable business models and sustainable competitive advantages) or other standards. Other strategies employ risk-oriented methods that aim to reduce or raise risk levels relative to a benchmark by employing low-volatility or high-beta strategies, for example. Most smart-beta indexes apply to equities, while others exist for fixed income, commodities and multi-asset classes.

Russell Investments offered its own definition of smart beta in a report it issued in October: transparent rules-based indexes designed to provide exposure to specific factors, market segments or systematic strategies.

Either way, there are no hard-and-fast rules determining what should or shouldn’t be included under the smart-beta banner. Some strategies, such as equal-weighting, are straightforward; others are complicated. And the picture gets more clouded as new smart-beta-related products roll off the assembly line.

“Many of these indexes have short track records when they’re picked up by an investable product,” says Ben Johnson, Morningstar’s global director of passive funds research. “It’s a diverse group that’s growing increasingly complex, which brings a steeper learning curve for investors.”

A prime example is the DoubleLine Shiller Enhanced CAPE mutual fund, a smart-beta offering launched in 2013 that comes with a lot of moving parts. The fund marries DoubleLine’s fixed-income expertise and an index based on economist Robert Shiller’s CAPE (cyclically adjusted price-earnings) ratio for assessing stock valuations. It aims to deliver a total return in excess of the Shiller Barclays CAPE US Sector TR USD Index by maintaining a core portfolio of debt instruments focused on global fixed-income sector rotation, with part of the holdings pledged as collateral against derivatives exposed to the most undervalued sectors in the stock market as measured by the CAPE ratio. The fund employs a momentum factor to mitigate the effects of potential value traps.

It’s complicated, yes, but at least in its full year in existence the fund’s retail share class product did well with a 17.70% return in 2014. It comes with a 30-day SEC yield of 3.19% and a net expense ratio of 1.24%.

In response to both the growing number of smart-beta-related products and their increasing complexity, the Financial Industry Regulatory Authority has included ETPs based on alternatively weighted indexes on its 2015 regulatory priorities list. Finra’s concerns include potentially high trading costs on indexes that are thinly traded and have wide bid-ask spreads; their potentially higher turnover and transaction costs versus traditional indexes; and questions about how indexes backed by impressive back-tested performance numbers will actually perform in the real world in different market environments.

Active? Passive? Does It Matter?
In describing how he developed fundamental indexing, Arnott notes that equal weighting goes back to the early 1990s, and minimum variance goes back to the 1970s with Robert Haugen. “Yet neither gained much in the way of assets until fundamental index came along,” he says. “Introducing that angered a lot of the traditional indexing and academic communities.”

Back in the ’90s, Arnott explains, he was troubled by cap-weighting and thought weighting companies by market capitalization would guarantee that if a company was overvalued and trading above its eventual fair value, it would also guarantee that your exposure to that company was higher than its fair-value weight.

“It’s a truism, but it’s also useless because you don’t know what fair value is,” he says. “But it occurred to me that if you weighted on something other than price or market cap, such as sales or book value, you’d eliminate that bias and would probably add some value. I didn’t test the idea until 2003.”

Arnott and his team looked at various measures and eventually realized it doesn’t matter which measure you use. “Fundamental index alpha has nothing to do with the fundamentals,” he says. “It has everything to do with severing the link with price, and it’s that mere fact of severing the link that adds value. Cap weighting basically says the higher the price of the company, the higher its future expected return must be; otherwise, it wouldn’t justify a higher weight. That doesn’t make sense.”