In my previous post on this topic I explained what beta is, since understanding it is integral to understanding the marketing concept known as smart beta.  In this post I’ll address smart beta and whether or not it’s worth allocating your investment dollars to ETFs that utilize it.

The concept is fairly simple to explain.  Passively-managed equity index funds and ETFs have traditionally utilized market capitalization weighting.  That means the amount of each stock in the index is based on the stock price times the number of shares outstanding.  In other words, larger companies (and in particular popular ones) are weighted more heavily in the index than smaller companies.  Some analysts have argued that such a weighting scheme risks overweighting companies whose stocks are already overvalued.   Smart beta is the term that the industry is now generally using to refer to passively-managed ETFs and mutual funds utilizing indices that weight their allocations to stocks using other factors than market cap.

CNBC.com attributes the first use of the term to professional services firm Towers Watson (now Willis Towers Watson), which among other things creates and manages retirement plans for businesses.  They assert it is a third pillar of investing, going beyond active management and passive management to “capture particular premiums, typically at very low cost.”  Other investment companies have since picked up on the term, applying it to their own unique methodology for structuring investable indices.  The Research Associates Fundamental Index (RAFI), for example, was created over a decade ago as an alternative to the standard S&P 500 cap-weighted index.  It utilizes company fundamental attributes such as cash flow and book value rather than market capitalization to weight the components of its index.   Today there are numerous passively-managed funds based on alternative weighting criteria such as stock volatility, momentum, company size, company quality, etc., all being promoted as smart beta.

The first question you might ask is whether or not any of these distinctions generate outperformance.  As I mentioned previously, these products haven’t been around long enough to definitively answer the question.  If one particular methodology were to significantly outperform the others, you would think that investors would tend to flock to the former and eschew the latter.  The fact that this has not happened to any large extent suggests that the differences between them have not been sufficiently demonstrable.

Another issue brought up in the last post is the fact that as a risk measure, beta is relative to each asset class.  Even if it were possible to reduce the risk within an equity asset class through some appropriate smart beta selection criteria, the impact on the overall portfolio would be pretty small.  Diversifying into other asset classes with lower correlations and with smaller risk profiles would be a far superior approach.  For example, suppose you might be able to reduce the risk of a 100% S&P 500 portfolio from a beta of 1.0 to a beta of 0.9 by replacing the fund with one tracking some alternative weighting methodology.  If instead you were to keep the S&P 500 index fund and simply add a bond fund to the portfolio, you would reduce the beta and the risk by a much greater amount.

If smart beta is not all that special, why is it being promoted so widely by the industry today?  Because it’s a way for investment companies to differentiate their passively-managed investment products.  In the past, active management had been promoted as the way to select mutual funds.  Active management is based on the premise that the manager is able to consistently pick better performing stocks or time the market, either of which requires his/her ability to predict the future.  The logical impossibility of that assumption, coupled with the relatively poor performance of actively managed funds over the last eight years, has caused passive investing to gain significant traction with investors at the expense of active funds.  But if you are an investment company trying to sell a passive investment product, you cannot differentiate it based on managerial skill the way actively managed funds do.  The concept of smart beta allows you to promote your passive fund as superior to other passive funds.  If nothing else, the term “smart” simply makes it sound better.

I am not suggesting that a fund or ETF utilizing a weighting strategy other than cap-weighting is a bad investment.  Over time we might discover that under certain economic conditions some weighting schemes turn out to be better than others.  But weighting is not the only factor to consider when selecting passive investments.  Trading and reconstitution strategies, for example, can have an impact on both risk and returns.  What’s most important is to avoid being swayed by marketing messages designed to make you feel that a particular investment is somehow superior.  Be sure to evaluate each investment on its own merits.