Smart beta booming despite a name everyone hates

2015 could be the year smart beta converts naysayers as investors face many market head winds that make returns ever harder to come by

Feb 1, 2015 @ 12:01 am

By Jeff Benjamin

Say what you will about smart beta, but, please, do not call it smart beta.

With few exceptions, true believers in the fast-growing hybrid of active management and passive investing are adamant that the strategy in general needs a better name.

“Nobody likes the name, smart beta, but everyone uses it,” said Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ. “Calling it smart beta seems to set a fund up for failure because it assumes it's the best. It also assumes that the more traditional products are dumb, which they're not.”

Across the industry, the strategy is identified as alternative beta, fundamental indexing, enhanced indexing and more. But it really just comes down to tweaking traditional indexing by weighting stocks based on metrics other than the market capitalization of the underlying companies.

Regardless of the name, products being sold using the strategies are booming, and 2015 could prove to be the year smart beta converts naysayers into believers as investors, faced with the specter of an aging bull market, rising interest rates and other head winds that will make returns ever harder to come by, seek new ways to capture return.

Morningstar has tried to take the lead in getting the industry on the same page by adopting the term “strategic beta,” which it applies to $402 billion in 479 exchange-traded products.

That's more than double the $195 billion Morningstar estimated was in smart-beta products at the end of 2012. Today, smart-beta assets make up nearly 20% of all exchange-traded products, up from 15% in 2013 and 12% in 2010.

“We're looking to identify the universe and cut through the clutter and marketing hype,” said Morningstar analyst Ben Johnson.

“We've found that strategic beta has largely been long on marketing hype and short on substantive conversations about the merits,” he added. “The various strategies have their own unique merit and performance cycles, but the strategies are certainly not all smart and they not going to look smart all the time.”


While it might sound silly, or even petty, to complain about general nomenclature, it is in many respects emerging as a kind of stumbling block to the true potential of a strategy that actually has a lot to offer.

For the most basic sense of smart beta, imagine an index fund that is constructed in just about any way except based on market capitalization.

The S&P 500 Index is a perfect example of a cap-weighted index, which by design is most heavily exposed to the largest companies making up the index.

By comparison, the Dow Jones Industrial Average is a price-weighted index, meaning each of the 30 stocks making up the best known blue-chip barometer is weighted based on its share price. If there were just two stocks in the index, for example, a $10 stock would have double the weighting of a $5 stock. Technically, that would make the Dow a smart-beta strategy.

As smart-beta strategies go, equal-weighting, which means just giving each stock in an index the same weight, is about as simple as it gets.

For example, the First Trust Nasdaq-100 Equal Weighted Index (QQEW), offers equal-weighted exposure to the stocks making up the Nasdaq 100 Index.

“Anything following a very transparent, rules-based rebalancing strategy and adopting a stock-weighting scheme that is not market-cap weighted would fall into the [smart beta] camp,” said Stephen Kwa, client portfolio manager at Schroders QEP, which prefers the terms structured beta and alternative beta.

“Cap-weighted really is the only true passive portfolio because there is no rebalancing, and capitalization changes automatically as the stock price goes up and down,” he added. “What everyone is essentially addressing is the shortcomings of cap-weighted indexes.”

In a somewhat awkward turn of phrase, Mr. Johnson of Morningstar described strategic beta as a “hybrid offspring of an active and a passive parent by making an active bet against the parents, at large.”

“But it's also rules-based, transparent and low cost,” he added.

But the rules can range from straightforward to something that almost looks like an active strategy.


The Direxion iBillionaire Index (IBLN), for example, screens public filings of between five and 10 individual billionaire investors to build a portfolio of their 30 most common holdings, which are then equal-weighted.

Then there is the Direxion All Cap Insider Sentiment ETF (KNOW), which screens the stocks making up the S&P 1500 Index, looking for secondary-market buying by corporate insiders to determine which stocks are most likely to outperform.

Where does smart beta fit in a larger portfolio?

Andy O'Rourke, managing director at Direxion Funds, believes it's not about replacing active or passive strategies, but supplementing them.

Because the strategy is index-based and depends on transparency, it is most commonly applied inside an exchange-traded structure. But it can also be applied inside a mutual fund wrapper, as is the case of the DoubleLine Shiller Enhanced CAPE Fund (DSEEX), which has nearly $270 million invested in it, according to Morningstar.

The fund identifies the most undervalued sectors of the S&P 500 based on a cyclically adjusted price-to-earnings ratio basis.

“There are parts of the markets that get overlooked,” said Jeffrey Sherman, manager of the 15-month-old DoubleLine fund.

Once the fund identifies the five cheapest sectors, it avoids the value trap by removing the sector that performed the worst over the previous 12 months.

“We want to avoid something that is cheap and getting cheaper, like financials in 2008,” Mr. Sherman explained. “We're looking for stabilization.”

A complete measure of the expansion and adoption of smart beta strategies is difficult to capture because it involves multiple variations that can be found in virtually every asset category or Morningstar style box.

But even the advisers who are embracing smart beta are doing so cautiously.

“I'm always open to ideas that are based on solid academic research,” said David Schneider, founder of Schneider Wealth Strategies and a user of smart beta. “But a lot of firms seem to just want to develop products based on back-tested data.

“It's just a question of is it a really good strategy or just something somebody figured out on a computer,” he added.

Michael Baker, a partner at Vertex Capital Advisors, doesn't use smart beta because his clients “just flat out don't get it. When they just don't understand something you find yourself constantly coming back to explain it over and over.”

Jason Hsu, co-founder and vice chairman of Research Affiliates, a firm widely recognized as an originator of smart beta, said its growing appeal is a result of hitting all the right buttons.

On a fee basis, smart beta competes with active management, but the various strategies can also stack up against the pure beta of an index fund on a performance basis.

But even as a smart beta proponent and true believer, Mr. Hsu recommends balance and proportion.

“Smart beta is a deviation from market-cap weighting, but there have been a lot of flavors created which have no theoretical underpinnings to them,” he said. “I would favor sticking with the low-hanging fruit, which are known to us, such as value, low-beta and momentum strategies.”

Mr. Hsu said smart beta is not a replacement for traditional cap-weighted indexing. “I think smart beta is a strategic core part of a portfolio, but... it's designed as a complement to cap-weighting,” he said.


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