Smart Beta: Debate the Term but Don’t Question the Trend

Many devotees of conventional index investing argue that any deviation from a market capitalization-weighted approach is not passive index investing at all, but rather a form of active management.

At the same time, some traditional active managers bristle at the notion of a rules- based strategy—no matter how refined—being classified as anything other than passive. In a way, both factions are correct. For some context on the exchange-traded fund (ETF) industry’s evolution, let’s first review its origins.

The ETF industry began in 1993 with market capitalization-weighted equity funds. The structural benefits of ETFs—transparency of holdings, intraday liquidity and tax efficiency—powered the industry’s growth to roughly $1.7 trillion. Over the past two decades, investors have sought out the structural benefits of ETFs in additional asset classes and strategies such as fixed income, commodities, alternative weighting methodologies and strategy ETFs.

In fact, I believe thanks to a growing investor preference for solutions in the ETF structure, the renaissance in index innovation has taken place almost exclusively in ETFs. Now let’s turn to how this innovation has been labeled and perceived.

As I argued in a previous blog post, classifications common in the mutual fund world don’t always translate well to ETFs. Strictly speaking, the Securities and Exchange Commission classifies WisdomTree’s fundamentally weighted equity ETFs as passive because they track Indexes. But these Indexes were in fact built by WisdomTree. We designed them to be different from market capitalization-weighted indexes, thus they have performed differently than their comparable market capitalization-weighted benchmarks over time.