You may have heard of an emerging class of mutual funds and ETFs called smart beta funds. But do these funds offer a compelling alternative to funds that already exist?
Let’s begin our inquiry with a definition: Smart beta funds – also called advanced beta, alternative beta, and strategic beta – are essentially index funds that weight their holdings in some strategic form that is different than the conventional cap-weighting of traditional index funds. In simple terms, smart beta funds are passive index funds with an actively-managed twist.
Since smart beta funds are not beholden to a particular weighting scheme, they are all over the map in terms of style and performance. There are various weighting strategies, dividend strategies, momentum strategies and volatility strategies. For this reason – and because these funds are relatively new to the investment world – it’s difficult to know if smart beta funds will prove valuable over time.
Smart Beta Funds vs. Index Funds
As an alternative to traditional index funds, investors are smart to do some shopping and compare costs and performance with smart beta funds.
For example, a popular smart beta fund, iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), has a low expense ratio of just 0.15% and its portfolio is structured to produce less volatility than a market-cap-weighted index fund. But although USMV is likely to show less downside in a bear market, it is not likely to capture the same upside as traditional index funds.
The USMV fund, which has been around since 2011, lost to the S&P 500 index in 2012 and 2013. But when volatility and downside pressure entered the picture in 2014 – and increased in 2015 – USMV beat the S&P 500. How the long-term performance will stand up to the major market indexes won’t be known until we’ve seen a full market cycle.
One of the biggest smart beta funds is the Guggenheim S&P Equal Weight ETF (NYSEArca: RSP), which weights its holdings just as its name suggests: It holds all the stocks in the S&P 500 index but targets an equal allocation to each stock, rather than weighting them by market capitalization. The result is higher allocation to smaller capitalization stocks, which would suggest greater long-term returns. RSP has in fact beaten the S&P 500 index for 10-year returns. But investors could get similar or better results buying a mid-cap index fund. And the expense ratio of 0.40% for RSP is significantly higher than most traditional mutual funds and ETFs that mirror a benchmark index.
Are Smart Beta Funds Really Smart?
Smart beta funds are basically an alternative – and often more expensive – class of index funds. From the perspective of marketing and retailing products, these funds are not much more than repackaged goods. They provide value to investors in the sense that they offer a convenient means of packaging combined index strategies into one fund.
However, smart shoppers don’t often buy products at convenience stores. For example, a smart investor could create his own all-cap blend by purchasing a large-cap index fund, a mid-cap index fund and a small-cap index fund and equally weighting each one. The investor could also use index funds, whether they are mutual funds or ETFs, with lower expense ratios than the smart beta funds. This self-made, strategic portfolio could produce better performance results – assuming it mimics the smart beta portfolio but at lower expenses.
So are smart beta funds really smart? In general, one could answer “Yes” to this question. But that’s because, in general, the investor herd is not “smart” enough to create their own smart portfolios.
The bottom line is that smart investors don’t need smart beta funds.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.