Is Your Smart Beta ETF "Smart"? | ETF Trends

2015 has been good to smart beta, gaining $63 billion in inflows and earning recognition as ‘buzzword of the year’ on Investopedia; Smart Beta has come to dominate new ETF products’ AUM growth and marketing dollars. Whether you call them ‘Strategic Beta’ or ‘Enhanced Beta ETFs’,  these strategies claim to fame is their professed ability to deliver alpha at lower fees than active funds while still outperforming “dumb-beta” passive  strategies.

Smart Beta strategies offer investors the best of both worlds: transparency through a rules-based approach, low expense ratios, and the opportunity to access alpha. The target audience is defined: the active portion of the index portfolio. The target competition is defined: active managers who run closet beta portfolios. And the recipe is simple: employ factor screens to select and weigh underlying stocks to provide tilts that have historically outperformed market-cap weighted indices and are expected to continue to do so due to inefficiencies in the market.  Which immediately begs the question: Is this outperformance for real, and will it continue?

I’ll start out with a disclaimer: I do believe in factors. I believe in factors that have been vetted and debated on extensive out-of-sample data, including international settings, over decades. What makes the smart beta products difficult to evaluate for investors is the emergence of hundreds of new or rebranded factors for which actual track record is limited. While all historical simulations   look great, they are no guarantee of future performance. Looking only at the top journals, the number of factors “discovered” grew from 1 per year in 1990 to 18 per year in the last decade. This seems highly suspect as the low-hanging fruit of true factors was most likely picked early.

Additionally, in earlier decades when the cost of data-mining was high, only factors based on economically sound principles were tried and tested. (Read: the factor model concept may now have as much or more marketing prowess as investment    promise).

Not only are these factors confusing for investors, it remains unclear if the excess returns can be attributed to the strategies. In a Journal of Portfolio Management study published in 2013, the authors looked at smart beta factor strategies such as minimum volatility, value, or fundamentals- weighted, etc. They inverted the signals from these sensible factor-based rules and expected to see the upside-down portfolios perform poorly. However, they discovered that reversing the factors, for example, using high volatility or inverse of fundamentals to weigh stocks, also outperformed the S&P 500! Paradoxically, using Malkiel’s blindfolded monkey approach, throwing darts at the Wall Street Journal, produced portfolios that did better than the market.