Smart-Beta ETFs: The Risks You Want

Smart beta isn’t smarter than cap weighting, but it is different, and that’s good.

The topic of smart-beta ETFs loomed large at the 2014 Inside ETFs conference and continues to resonate with a recent Bloomberg article and a Rick Ferri blog.

The Bloomberg article notes that smart-beta ETFs have grown in popularity despite their higher fees, and Ferri’s piece rightly points out that these products are often riskier than “plain vanilla” market-cap-weighted ETFs.

My own view is simple: Smart-beta products allow you to take the risks you want.

To be clear, I don’t believe smart-beta ETFs systematically beat the market. I also agree that their higher costs must be carefully weighed, especially considering the stiff competition: Plain-vanilla ETFs excel at delivering market risk at an extremely low all-in cost and in a tax-efficient, transparent wrapper.

But I also believe that not every investor wants pure-play market risk. As the old saying goes, investing is about eating and sleeping: You need returns to eat, but you also need peace of mind to sleep at night.

In other words, not every investor feels most comfortable riding the exact path laid down by the S&P 500 Index.

As an alternative, I see the appeal of fundamental ETFs like the PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-86). PRF strips a stock’s price out of the equation and instead allocates based on each firm’s economic footprint.

As such, the fund is likely to sell off a hot stock, unless that stock is backed by strong cash flows, dividends, revenue and book value. This should attract investors who take a dim view of stocks with three-digit price-earnings multiples.

I also like the Guggenheim S&P 500 Equal Weight ETF (RSP| A-73) because of its systematic rebalance to equal weight: It sells off the winners and buys stocks when they’re cheap. This approach should resonate with contrarians.

Still, PRF and RSP take more risk than funds like pure-play index funds like the SPDR S&P 500 ETF (SPY | A-97).

Market-cap-weighted funds like SPY favor the largest firms, which tend to be less risky. In contrast, equal-weighted funds like RSP hold smaller, riskier firms in greater proportion relative to SPY.

RSP’s elevated market risk shows up as high beta of 1.08. This means RSP will likely beat SPY in good times and lag in bad times.

In RSP’s defense, investors in the fund have taken more risk, but have enjoyed higher returns over one-, three-, five- and 10-year periods compared with the ETF.com broad-market benchmark. (See our fund report for the numbers.) This is not-risk adjusted outperformance, but it’s still an impressive record of higher returns driven by the fund’s specific risks.

PRF’s risks are more subtle. The fund also favors smaller firms and carries higher market risk. PRF pulls from a broader universe of 1,000 stocks and not the S&P 500, so it has a natural bias toward smaller firms.

While PRF has less market risk than RSP, it takes bigger sector bets, favoring financials and skimping on tech plays.

Overexposure to a certain sector cuts both ways: Investors in the PowerShares S&P 500 Low Volatility Portfolio (SPLV | A-47) saw its fortunes rise and fall in 2013, driven by its massive allocation to telecoms.

PRF also shows higher returns than the market over one-, three- and five-year periods. As with RSP, these are not higher-risk-adjusted returns, just higher returns and higher risk.

Lastly, it also makes sense to compare smart-beta ETFs to active mutual funds rather than comparing them with cap-weighted ETFs like SPY. Where an active mutual fund shares a strategy with a smart-beta ETF, the ETF offers the advantages of discipline, transparency, tax efficiency and low costs. At a minimum, the ETF can serve as an appropriate benchmark, if not an outright replacement to the active mutual fund.

Investors come in all shapes and sizes. Their investment products should, too. Investors who believe in a strategy like RSP and PRF are more likely to stay the course rather than sell off at the trough. This in turn might protect those investors from their own worst enemy: themselves.

At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at [email protected].