Wall Street loves a good marketing technique. It lets the industry sell products to unsuspecting investors that they probably don’t need.
And the current product buzzword circulating the Street is “smart beta.”
Essentially, smart beta funds use various fundamental screens — searching for factors like sales, earnings, book value, dividends or cash flows — to create or improve upon traditional indices. The hope is that by focusing on these factors, the new smart beta funds will ultimately outperform market cap-weighted funds like the SPDR S&P 500 ETF (SPY).
Here’s the rub, though: Not all smart beta products are going to be “smart.”
In the rush to get investors to bite on some of these things, Wall Street has been issuing smart beta funds like crazy — many with more and more complex underlying index requirements — to the point where the sector is starting to look like a potential minefield. When you start to look at too many factors, you begin to really resemble active management. (And we know just how great most active managers are when it comes to returns.)
To be honest, most smart beta products are going to fall flat in terms of their goals. But not all of them will be dogs. Here are five of the best smart beta funds to compliment your index funds.
Smart Beta Funds: Guggenheim S&P 500 Equal Weight (RSP)
Perhaps a simple smart beta strategy is best, and nothing could be simpler than the Guggenheim S&P 500 Equal Weight (RSP). RSP basically takes all the constituents of the benchmark index and equally divides them up to create its portfolio.
The reason behind this is pretty simple, too.
Most indices are created by weighting stocks according to their total stock market value, or market capitalization. So in the case of the S&P 500, Apple (AAPL) — with its $480 billion market cap — gets more weighting than $13 billion Range Resources (RRC). As a result, Apple can “move” the index much more than the smaller constituent RRC.
By equally weighting the index, RSP allows for these smaller stocks to shine. That focus on sharing the load has worked well for RSP — in the past 10 years, RSP has posted annual returns of 9.18% per year, vs. just 7.61% for the venerable S&P 500. Doesn’t sound like much, but over time, those percentage points add up.
Meanwhile, expenses for the $7 billion fund are pretty cheap as far as smart beta funds go. RSP only charges 0.4%, or $40 annually per every $10,000 invested.
Smart Beta Funds: PowerShares FTSE RAFI US 1000 (PRF)
When it comes to smart beta, Research Affiliates wrote the book and basically created the concept decades ago. As such, its RAFI line of indices is the standard-bearer with regards factor-based investing.
The PowerShares FTSE RAFI US 1000 (PRF) could be the hallmark of their efforts.
PRF holds more than a thousand U.S. stocks, but instead of weighting them according to market cap, it weights them according to series of various factors. The fund looks at fundamental measures of size, including book value, cash flow, sales and dividends. Each stock is scored, then is weighted based on that score.
What investors are left with is a value-style portfolio, with growth stocks only making up around 18% of its holdings. However, the fact that PRF does own some growth names as well as mid- and small-caps has helped the fund both the S&P 500 and traditional large-cap value funds over the past five years. Overall, PRF has managed to post a 25.5% annual total return during that time, vs. the S&P’s 20%.
Expenses are even lower than RSP at 0.38%.
Smart Beta Funds: iShares MSCI USA Quality Factor ETF (QUAL)
Created in conjunction with the Arizona State Retirement System, BlackRock’s (BLK) iShares MSCI USA Quality Factor (QUAL) smart beta fund is quickly becoming a winner among investors.
QUAL uses the broad MSCI USA Index as a base and then picks-out stocks that meet “high-quality” metrics. It scores stocks on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage. That creates a portfolio of stocks that currently totals 127, with tech being the largest sector weighting at 36%.
Research shows that high-quality earnings and low debt levels in stocks can consistently deliver better risk-adjusted returns than the broader market over the long haul. By exploiting these factors, QUAL hopes to deliver more oomph while removing some of the volatility and downside risk.
The fund is new and doesn’t have the track record of RSP and PRF, but results have been pretty good so far. Last year, its underlying index managed to post a 33.5% return, slightly beating the S&P 500.
The other kicker for QUAL: Expenses are dirt cheap at just 0.15%.
Smart Beta Funds: FlexShares Quality Dividend ETF (QDF)
While Northern Trust (NTRS) is mostly thought as a bank for affluent individuals, it’s also a huge provider of index funds. It’s also becoming a major player in smart beta ETFs.
Case in point: the $425 million FlexShares Quality Dividend ETF (QDF).
There are plenty of ETFs that focus on dividends as a way to weight their constituents. However, the bulk of these tend to just look at underlying high yields, payment histories and dividend growth. QDF takes this one step further by applying screens to weed out potential problems. By looking at factors such as profitability and reliable cash flows, QDF attempts to rank its holdings based on dividend quality.
QDF currently tracks 204 different firms and yields a healthy 2.92%. While that yield isn’t as high as some dividend-focused ETFS, the key is that investors are getting better quality dividend payers. High-yielding stocks with “sketchy” financials — like Frontier Communications (FTR) — won’t be found in QDF.
Expenses run at 0.38% annually.
Smart Beta Funds: RevenueShares Large Cap ETF (RWL)
Like the previously mentioned RSP, the RevenueShares Large Cap (RWL) smart beta ETF takes the classic S&P 500 and reweights the constituents to create its portfolio. This time RWL uses a company’s revenues as its guide.
The basic idea is that focusing on a firm’s revenues is key to finding value. There is some research that suggests that revenue, unlike other fundamental factors, is unique in the sense that you can’t manipulate it and can be applied equally to all members of an index. Metrics like price-to-earnings ratios and market caps can change as investors buy or sell a stock.
By doing this, RWL hopes to lower exposure to overvalued companies, while increasing exposure to undervalued ones before revenues are fully reflected in share prices.
It’s an interesting concept, and the $200 million smart beta fund has done pretty well. RWL has managed to outperform the S&P 500 over the last five years with annual average returns of 23.4%.
The only downside is that trading volume for RWL is weak and the expenses are a bit high compared to the pack, at 0.75%.
As of this writing, Aaron Levitt was long RSP.