Problem 3: Tracking
One of the glorious things about market-cap-weighted indexes is that they're comparatively easy to run. Once you own all the stocks you want in their market weights, you generally don't need to touch the portfolio except to reinvest dividends, handle corporate actions and deal with index changes. There's still a science to doing that well, but it's relatively straightforward.
Smart-beta strategies by definition are doing something different. They're holding securities in different weights, adjusting their portfolios to match their "smart" strategies, and often rebalancing regularly. All of that means that ETFs tracking smart-beta indexes often have a much more difficult time than their vanilla brethren.
Consider the iShares S&P 500 ETF (IVV | A-97). We won't bother with a chart, because it's literally impossible to tease out the difference in performance between IVV and the actual S&P 500 Index. By the numbers, it trails the index by precisely the amount of its expense ratio in any given year, with a variation of generally less than a basis point.
The iShares MSCI USA Minimum Volatility ETF (USMV | A-54) fares much worse. While it charges an expense ratio of 15 bps, on an average year, it trails its index by 22 bps. In a bad year, it trails by nearly 40 bps (see Figure 3).
Even something as seemingly simple as equal weighting can add significant variability to your returns. Guggenheim's S&P 500 Equal Weight ETF (RSP | A-72), has a median annual tracking difference of 57 basis points—more than its 40 bp expense ratio would suggest—and in its worst years, trails by almost 70 bps.
Problem 4: Trading
Finally, many smart-beta funds share something in common with all niche ETFs—they often don't trade particularly well. The reason this is particularly concerning for smart-beta products is that often the alternative products being considered—vanilla ETFs—trade very well. Put another way, if you're looking to invest in corn futures, you don't have many options, and will have to deal with some tricky trading to get at the corn ETFs. But global equities? There are dozens of funds trading at fair value and penny spreads, all day long.
Consider one of the fastest-growing funds of 2013, the Vident International Equity ETF (VIDI | F-39). Since its recent launch in November of last year, VIDI has pulled in more than $550 million in assets, making it one of the largest international equity ETFs on the market. Yet despite that initial size, it's struggled to find good on-screen volume. Consequently, the fund has traded at significantly different prices than fair-value might suggest (see Figure 4).
These kinds of premiums and discounts driven by flows aren't uncommon in smart-beta products, and for good reason. Because these strategies follow nonstandard indexes, they're more difficult for market makers and authorized participants to hedge against. That means they're more likely to allow the price of an ETF to drift from "fair" before stepping in to create or redeem shares.
None of these issues—trading, tracking, crowding and false alpha—is unavoidable. In fact, for the most part, they're very easy to spot using free tools like the analytics at ETF.com. As with everything in ETFs, you need to look closely before you leap. It's just doubly true when you're hunting for a better mousetrap. Because sometimes it's not the mouse who gets trapped.