What to do when smart beta looks like dumb beta

How to deal with clients when your smart beta ETF recommendation goes south.

Let’s say a financial adviser — not you, of course — recommends a few smart beta ETFs for his client’s portfolio. And unfortunately, those smart beta ETFs promptly head south. What should that financial adviser — not you — do?
If you recommend smart beta funds to your clients, it’s likely that, sooner or later, you’ll be in this purely hypothetical adviser’s shoes. Smart beta funds take several investment factors into account. They could, for example, invest in stocks of companies that consistently raise their dividends. Or they could buy stocks of companies with low volatility. Or they could use a combination of factors.
And that’s the problem. Wall Street sometimes favors some factors, such as low volatility funds , and later dumps them for other strategies. For example, the PowerShares S&P 500 Low Volatility ETF (SPLV) has fallen 4.94% the past three months, vs. a 3.99% gain for the Standard & Poor’s 500 stock index with dividends reinvested. The iShares Core High Dividend Fund (HDV) is down 1.80%). Both strategies were extremely successful at the start of the year.
And that’s the nature of the smart-beta beast. “The challenge with most factor strategies is that they require a long time to pan out,” said Dave Nadig, director of exchange-traded funds for FactSet Research Sytems. “Most good academic research would suggest that the premium associated with a given factor or combination of factors runs across something like a seven-year cycle. That means you, as an investor, need to be willing to hold pat on three losing years with the hope of outperforming in the next four. That’s a very significant behavioral challenge, no matter how good the math is. It’s for this reason that the biggest users of “smart beta” have been institutions with long time horizons and a capacity for risk: pensions and endowments.”
Most advisers don’t use smart beta funds as a main course, but as a side dish. “Smart beta funds that use factors other than market capitalization are simply a piece of a diversified portfolio,” said Stephanie Genkin, founder of Founder of My Financial Planner, a New York State RIA. “I use them in client portfolios in addition to the standard market cap weighted index mutual funds and ETFs. Sometimes they will do better than regular index funds and other times they may lag. I don’t see them as a fashion or going out of style but as an “accessory” that enhances a client’s portfolio.”
All well and good. But let’s say that an adviser — not you, naturally — included a smart beta fund as part of a portfolio and it promptly tanked. What should you do? “There is nothing that will you can tell a client after the fact that will make a client feel better if any investment swoons shortly after an investment is made into a fund,” said Wayne Bland, a financial adviser with Metro Retirement Plan Advisers in Charlotte, N.C. “That conversation and reasonable expectations has to take place upfront or the relationship will be damaged. It is our responsibility to clearly articulate the possibility of growth and possibility of a decrease in value.”
As an adviser, you should also question whether the smart beta fund you’re buying might be kind of dumb. “Smart beta takes advantage of market anomalies, and once that becomes popularized, the anomaly goes away because everyone starts investing in the process,” said Timothy McIntosh, an investment manager in Tampa, Fla. “Once you start to get asset flows into that category, you’re buying past performance and the stocks get richly valued.”
Jonathan Pond, a financial planner in Newton, Mass., says that if you’ve done your homework and a recommendation declines, consider buying more. “Buying is a more rational decision than selling it,” he said. That can be a tough sell. “Your client needs to sleep and have confidence in you,” Mr. Pond said. “There’s nothing wrong with saying, ‘We made a mistake,’ and selling it – or half of it.”
In short: Don’t fall for fads, use funds that suit your clients’ needs, talk to them before you make the recommendation, and admit your mistakes. One other thing: Don’t try to time smart-beta purchases and sales. (Not that you would, of course.)
“This always looks like a great idea, but in practice is enormously difficult,” said Mr. Nadig. “Some of the smartest minds in the business have been working on factor timing for years, and the record on it is mixed — at best.”