Smart Beta ETFs the Next Big Thing?

For those of us involved in financial services it is hard to check your Twitter stream or visit an industry website without seeing the term smart beta. ETF providers have really taken to this trend and have introduced many new ETFs based on some aspect of smart beta.

Nobody follows a trend quite like the folks who market mutual funds or ETFs and smart beta is the hip thing that all of the “cool kids” are doing. At a recent ETF industry conference sponsored by Morningstar (MORN) this was virtually all anyone was talking about in the sessions I attended.

What is smart beta and is it really smart?  Are smart beta ETFs the next big thing in ETF investing?

Smart Beta Defined 

According to Investopedia (for whom I am a frequent contributor):

“Investment managers that follow a smart beta investment strategy seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility. That’s because smart beta strategies are implemented like a typical index strategies in that the index rules are set and transparent. Smart Beta strategies will differ from standard indices, such as the S&P 500 or the Barclays Aggregate, in that the indices focus on areas of the market that offer an opportunity for exploitation.” 

We will attempt to expand on that definition a bit below. 

Factor investing 

Most smart beta ETFs take an aspect or a factor from a traditional index. Traditional index ETFs passively track a market value weighted index like the S&P 500.  Some popular factors include low volatility, momentum; equal-weighted indexes, dividends and quality are common factors. An equal-weighted index would give equal weighting to a huge stock like Apple (APPL) and to the smallest stock in terms of market capitalization in the S&P 500 Index.

An example of a smart beta ETF based on a factor is the Powershares S&P 500 Low Volatility ETF (SPLV).

This ETF invests in the 100 stocks in the index that have exhibited the lowest volatility over the past 12 months. A sound idea in theory and perhaps ultimately in practice.

Like many smart beta ETFs the inception date of SPLV was May 5, 2011 over two years after the low point of the markets during the financial crises. The index the ETF follows was essentially created in the lab via back-testing, much like the Peter Boyle character in the movie Young Frankenstein. This means that most of the “history” of this ETF is via back-testing and not real performance data. As a presenter at the Morningstar conference said, he’s never seen a back-test that did not yield a positive result.

Looking at SPLV’s results, the ETF trails the S&P 500 index in terms of trailing three year returns 12.95% to 14.77% on an average annual basis for the period ending 10/19/2015. However for the year-to-date period through the same date SPLV has gained 1.27% versus 0.41% for the index.

Looking at another measure, standard deviation of return which measures the variability of the ETF’s returns (up and down) over the three year period ending 9/30/2015, the standard deviation for SPLV is +/- 9.63% versus +/- 9.74% for the index. My guess is that a selling point of this ETF would be lower volatility but over the past three years the smart beta ETF is only fractionally less volatile than the index and an investor would have considerably less money if they had held SPLV over a more traditional ETF like the SPDR S&P 500 ETF (SPY).

Is an investment in SPLV a bad idea? I don’t know because I have no idea how this ETF will hold up in a pronounced bear market. Yes it has performed better than the full index so far in 2015 including the volatility in August and September. How will it do if we hit a rough patch like 2000-2002 or 2008-2009? Good question.

A growth area 

According to data from Morningstar as of 6/30/2015:

• There were 444 smart beta products listed in the U.S.
• These products accounted for $540 billion in assets under management which was 21% of all U.S ETF assets.
• Of the new cash flows into ETFs over the past 12 months, 31% went into smart beta products.
• The assets in these products grew 27% over the same period.
• A quarter of new ETF launches over the past five years were smart beta products.

Who uses smart beta ETFs? 

From what I have heard and read smart beta ETFs are being used largely by financial advisors and institutional investors versus individuals. You might say so what? These folks are likely investing your money either via your relationship with a financial advisor who may use them in a portfolio or use a TAMP (turnkey asset management program) program offered by a third-party to manage your money.

Reasons to use Smart Beta 

Morningstar cites several reasons investors and advisors might consider smart beta ETFs:

• To manage portfolio risk
• To enhance portfolio returns
• For tactical asset allocation, meaning an allocation that is based in part on the advisor’s assessment of market conditions
• Reducing fees versus actively managed mutual funds
• To use an active strategy grounded by an index core

Many, including me, view strategic beta as a form of active management. A presenter at the Morningstar conference suggested that any smart beta ETF with an expense ratio of 50 basis points or higher should not be considered as this is the lower end of the fee range for the better actively managed mutual funds offering an institutional share class.

What does this mean for individual investors? 

Again I suspect that most of the money invested here will be institutional or via financial advisors. As an individual investor working with a financial advisor who suggests using smart beta ETFs in your portfolio, you should ask them to explain their rational. Why are these ETFs a better choice than an asset allocation strategy using more traditional index products?

If you will using smart beta ETFs on your own, be sure that you fully understand the underlying index which was likely created post-financial crises via back testing. Understand that smart beta strategies may look good on paper but in reality they can take a number of years to prove themselves.  Lastly understand that strategies that look good in testing may not work as well when millions of dollars are actually invested there real-time.

For financial advisors 

Most financial advisors that I know are very deliberate in testing new products and investing ideas before using them with clients. With the rise of third-party advisors such as TAMPs and ETF strategists, financial advisors still need to understand the underlying products and strategies being used to invest their client’s hard-earned money.

The Bottom Line 

Smart beta is the next evolution of ETF investing or so say the firms trying to gather assets into these products. I’m not saying that smart beta isn’t an enhancement or that I am against new investing inovations. I am leery of any investment vehicle designed to solve a problem or fill a role in portfolios that have not gone through a full stock market cycle. With any investment vehicle that you are considering, be sure to fully understand the benefits, the risks and the costs. How smart is smart beta? We really won’t know until the market goes through a full cycle that includes a significant correction.

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