The most tedious dinner table arguments aren’t about politics, they’re about definitions. Whether it’s trying to pin down what makes one author a “horror” writer and another a “thriller,” or whether Eric Clapton should be considered “blues” or “rock,” nobody really wins.
The biggest argument in the ETF nerdo-sphere for the past few years has been around what to call these quant-driven strategies that have been around since the invention of the calculator. Towers Watson, an institutional investment consultant, is generally blamed for coming up with the actual words “smart beta” in the early 2000s, and like it or not, it’s stuck.
Agreement Is Challenging
But have fun trying to get anyone to agree on what it means. At the core, I often start from the position that smart beta is “ABMC”: anything but market cap. It’s a good starting point, but it’s incredibly broad. It can include anything from a simple equal-weighted strategy, a Research Affiliates fundamental index, a value fund or some incredibly complex and expensive multifactor black-box ETF.
Having the label is helpful though. It finally gives us a bucket in which to stick a slew of interesting strategies where we never could before. Without the label, I could tell you that I think low-volatility strategies and revenue weighting were interesting, and different, but I couldn’t find a way to stick them in the same list.
The challenge for us now is separating the wheat from the chaff. With hundreds of ETFs claiming the title, there are good and bad products out there, and figuring out the difference is even more crucial than, say, picking the right cap-weighted large-cap equity ETF. As an ETF Report reader, you’ve probably already learned to poke under the hood of an ETF before buying or recommending it. With a smart-beta ETF, I think you need to add a few more questions to your due diligence:
- When will the strategy work? Almost all smart-beta ETFs have times when they’ll do well and times when they’ll underperform. Strategies that lean on a few factors often need a full business cycle—as long as five to 10 years—to work their magic. That requires a lot of patience.
- Is it worth the cost? Smart-beta strategies are universally more expensive than the cheapest bulk-beta ETFs. Sometimes the price difference is small, sometimes it’s large. Any ETF issuer should be able to articulate solid reasoning for why they charge more. “Because we can” is not a good answer.
- Where does it fit? Nobody I know has a one-ETF portfolio. If you’re considering a smart-beta addition, ask yourself how it changes the complexion of your entire portfolio, not just how it works in a vacuum.
Last, there’s one question you should always be asking: Can you do better? It’s easy to fall in love with a cool new ETF. Trust me, I know. I read index methodology documents for fun. But every ETF has competition. With momentum ETFs, you’ve got 28 funds to sort through. U.S multifactor? 139 funds. It’s a big world out there, and once you go smart beta, there are no “easy” buttons to press.