How Smart Are ‘Smart Beta’ Funds?

As it turns out, that low-cost traditional market cap-weighted index fund might be letting you down — or at least, that’s the story according to the growing group of supporters of “smart beta” or “enhanced” indices, which try to mimic strategies used by active management.

Since the dawn of indexing, most measures — like the venerable S&P 500 — and the funds that track them have been created by weighting stocks according to their total stock market value, or market capitalization. That basically means Exxon Mobil (XOM) with its $420 billion market cap gets more weighting in the S&P 500 than last-place Zoetis (ZTS), the pet-pharma firm with a $15.5 billion market value. As a result, Exxon can pull the index — up or down — much more than the smaller constituent.

The same can be said for bond indices, where most are constructed based on the amount of debt outstanding. The more bonds issued, the higher the placement in the index.

But in recent years, several academics and market pundits have poked holes in that approach.

First, according to analysts, one of the major problems with standard indexing is that along with all the “good” companies, you get the “bad” ones as well, which drags on potentially market-beating returns. Secondly, as an individual stock gets more expensive, its index weighting can grow significantly. That leaves the index’s overall value vulnerable if the stock reverses course and begins to crash.

That’s where smart beta comes in.

The Rise of Alternative Indexing

To combat these issues, index and fund sponsors have rolled out new products that tweak conventional market measures.

The key to these new smart beta funds is in how the indices are constructed. By using various fundamental screens — that search for factors like sales, earnings, book value, dividends or cash flows — or simply by equally weighting all the constituents in a traditional market cap-weighted index, issuers hope to overcome the problem of adding too many “bad” firms to their respective indices.

So far, the strategy is working for many of these funds … but not all.

Research Affiliates, the leading and original firm to offer fundamental indices, has been one of the better performers. The firm’s RAFI series of indices — which rank stocks based on book value as well as trailing five-year average cash flows, sales and dividends — have managed to outperform more traditional indices. Last November, a paper by Duke Economist Edward Tower showed that a portfolio of two RAFI funds outperformed comparable Vanguard funds by an average of 2.57 percentage points per year during the period from March 2007 through June 2012.

Longer-term studies also have indicated that fundamental could be the way to go. Research by London’s Cass Business School showed that 13 alternative index methodologies produced higher returns than a theoretical market cap-weighted index from 1968 to 2011 when looking at the 1,000 largest U.S. stocks.

Much of that outperformance could be attributed to the fact that alternative indexing methodologies tend to lean toward small-cap and value stocks, or both. Over long periods of time, both small/midcaps as well as value stocks tend to outperform. So while there’s still plenty of large-cap growth muscle in many smart beta funds, the hefty exposure to these other firms have provided enough “oomph” to help many alternative indices outperform more traditional market measures.

Should You Bite?

While this sounds like a great pitch to dump your shares of the Vanguard S&P 500 ETF (VOO), keep in mind that fundamental indexing does have some downsides, too.

For example, in periods of rapid expansion, when growth stocks are in fashion — such as the dot-com days, the run-up to the Great Recession and perhaps today’s bull market — many alternative indices fall by the wayside.

Take the PowerShares S&P 500 Low Volatility (SPLV) for example. The fund tries to smooth out the magnitude of asset price fluctuations over time by betting on those firms in the S&P 500 that … well, don’t jump around as much. However, when Fed Chairman Ben Bernanke began his taper talk, SPLV actually dropped far more than the S&P. The reason? A heavy reliance on dividend payers and the potential effects of rising interest rates on those firms.

So, fundamental indices can fall flat on their goals.

Then there is cost to consider. Given the complexities of creating some of these fundamental indices, expenses for the funds are higher. For example, Guggenheim S&P 500 Equal Weight (RSP) has an expense ratio of 0.4%, or $40 a year per $10,000 invested. That compares to a rock-bottom 0.09% for the market cap-weighted SPDR S&P 500 ETF (SPY). Over time, costs do matter — especially if you back the wrong smart beta fund that only matches or underperforms a more traditional index.

Bottom Line

Despite these challenges, fundamental indexing is gaining prominence across Wall Street and might have a place in your own portfolio.

While I wouldn’t go out and dump my broad index holdings just yet, they do make sense in a “core & explore” situation. Taking some portfolio allocation toward one or more of these new-styled funds while keeping the bulk in bread ‘n’ butter indices could provide just enough extra return to play a few rounds of golf.

Over the long haul, the combo of the two should provide enough zig and zag to even out just right.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

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