Almost half of exchange-traded funds qualify as smart beta funds under the broadest definition of the term—anything that tracks an index that isn’t weighted or selected by market capitalization.
Despite that, they only represent about 22% of total assets under management and only captured 7% of flows in 2020, according to Elisabeth Kashner, director of global fund analytics at FactSet. Market-cap-weighted ETFs are still capturing the lion’s share of annual flows, at 70%, and actively managed ETFs are grabbing 12%, up from 0% five years ago.
Smart beta’s skimpy flows may be partially attributed to perceptions that there are too many out there and not enough differentiation from plain vanilla funds, observes Nate Geraci, president of The ETF Store.
“One of the concerns is that a number of smart beta ETFs are simply index funds in disguise,” he said. “There have been a lot of questions about, what exactly am I getting for that higher cost, and is it worth it.”
Still, ETF market participants see a bright future ahead for the alternatively weighted index space, whether that’s defined strictly as a way to break the link between a stock’s price and its weight in a portfolio, or factor investing, or new ways to look at weighting based on theme.
Market Environment Change
The recent market environment until late last year rewarded growth-focused, market-cap-weighted indexes like the S&P 500. More recently market participants were rewarding value and small cap strategies, believing that the U.S. economy will sharply rebound following the worst of the pandemic.
Rob Arnott, founder of Research Affiliates, notes in his forecast that if the shift to value holds, strategies such as fundamental indexing and equal weighting will do well since they outperform value indexes.
These types of strategies naturally trim highly valued stocks and buy those that have lost money, earning a rebalancing alpha, he explains, all things being equal.
Alternatively weighted strategies have a value tilt, he remarks, and strategies such as fundamental indexing and equal weight outperformed value indexes.
He points to the Invesco FTSE RAFI U.S. 1000 ETF (PRF) as an example. It was up 51% on a one-year basis as of mid-June, up 15.4% on a three-year basis and up 14.8% on a five-year basis.
Comparatively, using the iShares Russell 1000 Value ETF (IWD) as a stand-in for the Russell 1000 Value index, IWD rose 43% on a one-year basis, 12.6% on a three-year basis and 12% on a five-year basis. The SDPR S&P 500 Trust ETF (SPY) is up 43% on a one-year basis, up 17.2% over three years and up 17.3% on a five-year basis.
“True smart beta strategies did very well, beating the value indexes handily,” Arnott added. “Now that value is making a comeback, it’s likely that they’ll shoot the lights out.”
He’s optimistic that alternatively weighted indexes’ gains will continue since they outperformed value when value prices fell and recovered.
“That’s pretty cool, because value usually wins,” he noted. “So if the 2020s are a decade of value beating growth handily—which I think the decade will be—strategies that beat value are going to produce remarkable results.”
Arnott narrowly defines smart beta as strategies that break the link with price. That sets him apart from others in the industry who tend to lump factor investing and smart beta in the same category.
Fund Issuers Outlook
Big issuers originally dominated smart beta issuance, but Geraci suggests one way for smaller issuers to gain market share is by making these index-based ETFs use more active share, what he calls using “higher octane” strategies.
Some examples are the $208 million Alpha Alpha Architect U.S. Quantitative Value ETF (QVAL), an equal-weighted index of U.S. value stocks, with screens for forensic accounting and earnings quality, and the $91 million Alpha Architect U.S. Quantitative Momentum ETF (QMOM), an equal-weighted index of U.S. stocks with strong and consistent momentum.
“I see that as a path to success, because advisors are constructing portfolios by taking a core and satellite approach—where the core of their portfolios comprises very low-cost, broad-based exposure—and then they’re taking more concentrated, higher-octane bets with the remaining portion of the portfolio,” Geraci explained.
Another example of a “high-octane” ETF is the SoFi Social 50 ETF (SFYF). It tracks an index of 50 U.S.-listed stocks most widely held in self-directed brokerage accounts of SoFi Securities, based on highest weighted average value.
This “wisdom of the crowds” index is rebalanced monthly, so the holdings might drastically change month to month to capture new trends, explains David Dziekanski, portfolio manager and partner at Toroso Investments, which subadvises the SoFi fund.
He concurs with Geraci that these smart beta funds can appease a client’s interest in what’s hot, but still let an advisor keep most of the portfolio in passive, plain vanilla funds.
“If your clients are asking you about some of these hot names and what they should be doing about it,” he said, “this is a safer way to do that, rather than allowing your clients to actually buy some of these stocks on their own.”
Amrita Nandakumar, president, Vident Investment Advisory, sees more permutations based on factors and themes, such as those based on market trends. She also points to funds that combine factors and themes to affect weighting. Some of the ETFs that combine technology and momentum do that, but that could expand.
An ETF that Vident subadvises, the Democracy International Fund ETF (DMCY), overweights investments in democratic countries while underweighting those in authoritarian countries: “The theme drives the weighting.”
Increasing Returns Via Smart Beta
Rob Nestor, senior advisor to Rafferty Asset Management, forecasts a bright outlook for alternatively weighted indexes: “If we enter a period of low equity returns and/or volatile markets—which many are predicting—I think interest in deviating away from classic market-cap-weighted indexes is only likely to increase.”
Factor investing may see greater acceptance as investors are becoming increasingly aware of areas where there is clear evidence of excess return.
“There’s been a multiyear explosion, largely driven by momentum and minimum volatility,” Nestor added.” Now with rotation recently into value, the understanding of all of that is so much more widespread. And it goes back to my first reason, the lower equity-return expectations going forward and increased volatility.”
When it comes to alternatively weighted strategies, Arnott recommends financial advisors should research whether a particular strategy is trading cheap or rich relative to its history. He warns that cheaper strategies often have a disappointing recent performance.
“All too often, the temptation is to buy what’s worked best over the last three years,” he said. “And that’s a wonderful way to buy high and sell low.”
Arnott says investors ask him which RAFI index may produce the most alpha over the next 10 years. His choice is the original RAFI index because of its simple rebalancing mechanism. Humans tend to want more complex investing strategies, but the more complex those are, the greater the chances they won’t work.
“Some of the advantages that ordinary cap weighting has over all active strategies, and all smart beta strategies, are simplicity, low turnover, low costs,” Arnott noted. “And the role for any active ETF or smart beta ETF is to find cap weighting’s Achilles’ heel and fix it. With a lot of moving parts, you run a risk of not fixing it.”