Index funds became popular over the last four decades because they're simple, conservative and low cost. A different kind of exchange-traded fund is drawing record cash by promoting better returns with the same stocks.
Known by names such as smart beta and fundamental indexing, they weigh stocks differently — by focusing on dividends or sales, for instance. Supporters are quick to note that some methods, such as eliminating price rankings, result in returns that beat the Standard & Poor's 500 Index over the last five years. They're slower to note that fees can be 10 times higher than a traditional ETF.
“It feels like an inflection point for these strategies,” Daniel Pytlik, who helps oversee $288 billion at Bank Julius Baer & Co. in Zurich, said. “There seems to have been an acceleration of both demand for and supply of smart beta. Lots of things are going on in terms of the debate around the topic.”
(Is smart beta a smart investing idea?
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ETFs guided by the philosophy that you can boost performance by changing the way benchmark measures are put together got $43 billion last year, bringing assets to a record $156 billion as of the end of last month, data compiled by Bloomberg show. Securities from the WisdomTree Japan Hedged Equity Fund to the Guggenheim S&P 500 Equal Weight ETF are raking in cash and charging higher fees, raising concerns about how well investors understand them.
Calling an ETF smart beta is a marketing tactic designed to fool buyers into thinking it is infallible, said Rick Ferri, who helps oversee $1.3 billion for clients as founder of Portfolio Solutions in Troy, Mich. In reality, they lag behind more traditional gauges for extended periods and add risk.
“It all looks and sounds good on paper, but the guarantee is that it is going to cost you more money, you are going to take more risk, and you can underperform for a long time,” Mr. Ferri said. “If all these people are outperforming the market, who is underperforming? There is no such thing as a free lunch. The product providers are selling the sizzle rather than the steak.”
Smart beta occupies a middle ground between passive funds such as the Vanguard 500 Index Fund, founded in 1976, and the active management popularized by firms such as FMR's
Fidelity Investments. Designers build their own indexes or change existing ones, trying to boost returns by ranking companies not by price, but by measures such as volatility and dividend payments.
VARYING INFLUENCE
The S&P 500 is size-weighted, meaning that stocks such as Apple Inc. and Exxon Mobil Corp. can be as much as 163 times more influential than the smallest companies. Weighing every company equally, regardless of size, so that each takes up 0.2% of the index will change its return over time.
Stripping out market weights was a tactic tailor-made for American equities in 2013, a year when almost every company rallied. A total of 460 stocks in the S&P 500 advanced, the most since at least 1990, as the U.S. Federal Reserve pledged to keep interest rates near zero percent. The biggest 100 companies in the gauge limited its performance, rising 27%. Apple gained 5.4% and Exxon increased 17%.
Buying the biggest exchange-traded fund on the S&P 500 the moment equities bottomed in 2009 has returned 175%. Rearranging the ETF to remove size biases has resulted in a gain of 256%, according to data compiled by Bloomberg. The Guggenheim equal-weight ETF, overseen by a unit of Chicago-based Guggenheim Capital, acts that way. It lured almost $2.2 billion last year, the most since its inception in 2003.
Since the largest companies get no extra space in Guggenheim's fund, it behaves like a value investor, loading up on lower-priced shares.
While reducing the influence of popular companies generates higher returns over the long run, it's no guarantee of success every time, said Paul Bouchey, who helps oversee about $120 billion at Parametric Portfolio Associates in Seattle.
“Sometimes value is going to hurt you, sometimes it is going to help you,” Mr. Bouchey said. “But people are starting to realize that fully following market consensus, through every period, is maybe not the best way to get exposure.”
The Dow Jones Industrial Average, the 117-year-old American equities benchmark index, ranks its members by the price of their shares rather than by their overall size.
(Bloomberg News)
