The term “smart beta” has become popular in the exchange-traded fund market as a way for investors to avoid buying equities when prices are high.
With the Standard & Poor’s 500 index hovering near record highs, finding a way to value an investment aside from its market capitalization makes using smart beta enticing.
Christian Magoon, an ETF pioneer and founder of Amplify Investments in Downers Grove, Illinois, says the simplest definition of smart beta is that it’s a way to weight a security on something else than its market capitalization — or the value of its outstanding shares. Beta means how risky a stock or portfolio is to the broader market.
“There’s been research shown that valuing a security based on factors other than market capitalization has some performance and diversification benefits,” he says. “The idea is how can you beat the S&P 500 but still own the S&P 500?”
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Smart beta has its roots in academic research from University of Chicago professor Eugene Fama and Dartmouth professor Ken French, who discovered investment factors such as a company’s size, a firm’s price-book ratio and market risk proved to outperform the basic S&P index over time. Since then other factors have been added.
One of the first firms to create indexes based on investment factors was Research Associates in 2005, and it’s grown from there, says Eric Ervin, chief executive officer of Reality Shares in San Diego.
Ervin calls smart beta ETFs an evolution from original ETFs, which are passive investments based on existing indexes like the S&P 500. The new ETFs are similar to what active managers do — selecting stocks based on certain criteria — but ETFs are cheaper since they’re based on a rules-based index, he says.
Magoon and Ervin say smart beta ETFs offer potential, but investors need to know the difference between these and traditional index ETFs.
They aren’t well tested. Ben Johnson, director, global ETF research at Morningstar, says whether or not these ETFs actually work “is the million-dollar question. I would say — this is somewhat an unsatisfying answer — really that only time will tell.”
Magoon says while variables such as favoring dividend stocks historically proved to do better than the broader market, it might be the case that they worked because not a lot of people knew about them.
“Now that these variables are popular and there is a lot of money invested in those characteristics, it could influence the future returns and lower those returns,” he says.
It’s not unlike when investors start to chase the “hot” stock of the moment; that money can start to affect how the stock acts. Ervin says an example this year is how many people sought to buy dividend-paying stocks and ETFs as they sought yields that are higher than the U.S. Treasury market.
“You’ll see a lot of people owning significant amounts in utilities, telecoms and energy. Those are really small representations of the S&P 500, so people are making a big bet that these small sectors will grow and continue to grow. That’s a recipe for trouble,” he says.
They’re not always smart. Johnson calls “smart beta” mostly a marketing term, preferring to call these “strategic” beta ETFs. “They’re not going to be smart all the time. There’s going to be periods of underperformance and outperformance by many of these strategies,” he says.
Ervin and Magoon say just as there are business cycles, there are also cycles for strategies. For instance, Magoon says, since the financial crisis of 2008-2009, growth stocks have outperformed value stocks until just very recently.
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“You have to understand that smart beta is not a magic wand and will always outperform. It’s just giving you access to factors that may outperform at certain times,” Magoon says.
They require more research. Unlike passive ETFs that follow the major indexes, like the SPDR S&P 500 Trust (ticker: SPY), which are fairly easy to understand what securities are included, smart beta ETFs require much more due diligence by the investor.
“You can’t just focus on the name and the ticker. There’s more to it than the old-fashioned large cap S&P Index,” Ervin says.
Magoon uses the example of two Vanguard dividend-paying ETFs, Vanguard High Dividend Yield ETF ( VYM) and Vanguard Dividend Appreciation ETF ( VIG), to demonstrate how they trade differently.
“There’s a decent amount of research that says in a rising interest rate environment, the dividend stocks you want to own are the ones growing their dividend since they can provide a hedge against rising rates,” he says. “If you own the high dividend-paying stocks, they probably won’t grow their distribution and they may fall in value. If you owned the two Vanguard dividend ETFs and didn’t pay attention, you could see different performance results just because of the variable you’re exposed to.”
They cost more. The allure of ETFs is their low cost. These strategies are much cheaper than actively managed mutual funds, for example, but they’re more expensive than simple ETFs.
“You are going to pay a higher fee,” Magoon says. “The idea is you’re taking on the risk and willing to pay more for the exposure and it’s going to be worth it.”
Johnson and Magoon say lower fees tend to deliver better investor outcomes.
“Fees may be the only reliable predictor of future performance,” Johnson says.
For instance, the SPDR S&P 500 Trust ETF has an expense ratio of 0.09 percent, while the PowerShares S&P 500 Low Volatility ETF ( SPLV), which focuses on S&P-listed stocks that don’t have big price swings, has an expense ratio of 0.25 percent.
They won’t save you from losses. While these strategies may be different than the market capitalization-based ETFs, if the broader stock market plunges, investors still lose money, just perhaps not as much.
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“These aren’t a magic cure-all. If the whole market goes down the tubes and we have another bear market like we saw following the bursting of the tech bubble or following the financial crisis, it’s not like the S&P 500 will be down 35 percent and your strategic beta fund is only down 5 percent,” Johnson says. “That’s not a realistic set of expectations given that most of what you’re getting is still equity market exposure.”
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5 Facts to Know About Smart Beta ETFs originally appeared on usnews.com
