Retirement » ‘Smart beta’ funds: Are they really smarter?

Smart beta funds are the new black. Just one question: What does smart beta mean?

Trying to round up all the strategies that fall under the smart beta umbrella is a little bit like trying to herd cats. They’re all over the place, each with different notions on where to go and how to get there.

Even the name is up in the air. Yet, despite the disorder, smart beta may be more than marketing hype.

Uniting characteristics

Smart beta funds — also called strategic beta, alternative beta or advanced beta — do have a common thread. They are basically index funds, but they differ from the usual index funds that are weighted by the market capitalizations of the companies that make up the index. Instead, the companies in the index are arranged by something other than size.

Here’s another way of putting it: They are all passive funds making an active bet, according to Alex Bryan, analyst on the passive strategies team in manager research at Morningstar.com.

An extremely brief history of the market-cap weighted index

Indexes such as the Standard & Poor’s 500 index or the Russell 2000 are weighted by the market capitalization of the companies in their respective index. The bigger the company, the more weight it gets in the roster.

This is just arithmetic. Why did there develop such an interest in these cap-weighted indices? asks Marc Reinganum, Ph.D. senior managing director and chief quantitative strategist at State Street Global Advisors.

Back in the mid-20th century, a couple of academic ideas, including the Sharpe ratio, a measure of risk and return, stated that there was an optimal portfolio that would maximize returns for a given level of risk. This market portfolio, this cap-weighted portfolio, maximizes the Sharpe ratio, says Reinganum.

The 1980s and 1990s happened to be a good time to be a very big company.

It was a good environment for all equities, but especially for large-cap equities. That means it was good for indices that give heavy weight to large companies, that give weight in proportion to the size of the company, he says.

Though passive investing has turned out to be pretty great, some people thought it could be improved and endeavored to build a better passive fund.

See-through strategies

As with index funds, the strategies that smart beta funds use should be out in the open. Typically they are less proprietary and research-driven than strategies used by a purely active fund. But they’re still slightly more active than a passive fund.

The way I see smart beta funds, they are meant to be low-cost, index-like, lower-turnover funds. They are an effective way of capturing better exposure to the equity market. I would tell (investors) to largely ignore the more complex, expensive options that promise too much, says Jason Hsu, co-founder and vice chairman of Research Affiliates, a pioneer in fundamental index strategies.

With no unifying way of weighting stocks, they can be weighted in any number of ways, depending on their objective.

Morningstar’s taxonomy groups the funds by strategy, or what they are trying to accomplish.

You have everything from dividend strategies to fundamentally weighted strategies, momentum strategies and quality strategies, Morningstar’s Bryan says.

Despite the wide array of different strategies that these funds cover, it really boils down to several factors: overweighting value stocks, stocks that are cheap; maybe overweighting small-cap stocks; or they may be overweighting quality stocks. Those are the three main tilts that these funds take, at least on the equity side, Bryan says.

Strategic beta fund performance

So how do these strategic beta funds fare against the market-cap weighted S&P 500? The accompanying chart shows that over three and five years, these funds underperformed that benchmark, but over 10 years, smart beta ETFs show a slight edge. Note that the ETFs are considerably cheaper than their mutual fund counterparts.