Smart Beta Is Not Smart for Everyone

Journal of Financial Planning: March 2014


Rick Ferri is author of The ETF Book. He continually monitors and evaluates the latest trends related to index funds and ETFs. His research appears frequently in many major media outlets.

To smart beta, or not to smart beta; that is the question. Whether tis nobler to suffer the slings and arrows of rebuffing this popular investment trend whilst retaining independent thought, or to embrace it for the sake of conformity and the hope of discovering an alpha? Aye, there’s the rub, for when the soul knows what is prudent as the mind becomes greedy, we must give pause.

Low-fee, market-tracking index funds and exchange-traded funds (ETFs) are made for the soul. They replicate as close as feasible cap-weighted market benchmarks in an extremely low-cost manner. The concept is simple: earn your fair share of a market’s return and your performance likely will be well above the average actively managed portfolio over the long term. 

According to data compiled by the Investment Company Institute, money began flowing out of actively managed mutual funds and into traditional index funds about a decade ago and has accelerated over the years. Today, most large index funds and ETFs track cap-weighted benchmark indices. 

In 2004, a bold initiative was taken in the ETF industry that gave active managers a new lease on life. PowerShares launched ETFs that followed highly quantitative strategies that selected few securities and were weighted using alternative methods. PowerShares called its products an index fund although the cost of management was high by index fund standards, but its expenses were low by active management standards. 

The SEC decided to allow PowerShares to market its ETFs as an index-tracking product because there was an index of sorts (the Intellidex Index series) underlying the strategies. The SEC was essentially stating that any investment strategy can be classified as an index if there is a mechanized process behind the selection and weighing methodology. 

Fast forward a few years and witness the explosion of products following “strategy indexes.” With the benefit of perfect hindsight, index providers pumped out hundreds of hypothetically superior market-beating strategy indexes. Several years ago, I put a label on all these methods—“special product indexes” or SPINdexes for short. 

You know you’re looking at a SPINdex when the methodology has no purpose except to be licensed and sold as an investment product. The SPINdex revolution has spawned spiffy sounding names such as fundamental indexing and smart beta. 

Smart beta has become a catchall for any index weighing strategy that doesn’t follow a capitalization weighting methodology. The strategy may weight by fundamentals such as price-to-book, volatility, or a combination of factors.

To answer the question; to smart beta, or not to smart beta, one must look beyond the hype. In some form or another, smart beta strategies can be linked to Fama-French research on factor investing. When a stock portfolio deviates from cap weighting, additional risks beyond market risk are introduced. In an efficient market world, a higher risk portfolio is expected to have a higher return over time. Fama-French found that these additional risks (or betas) did provide risk premiums that have historically added to the return of a dumb beta portfolio. This is all before fees, of course. 

Adding extra portfolio risk adds to the prospect of a higher return, but that’s not a free lunch. It’s a risk allocation decision. 

In my recent interview with David Blitzer, managing director and chair of the S&P Dow Jones Index Committee, referring to the S&P 500, he said, “There are a virtually infinite number of ways to reweight 500 stocks and some people are running around giving these special names, but it’s still Fama-French.” (Read the interview at

I cannot tell you if factor-based strategies will reward investors in the future, but I can tell you there are two things that will occur. Clients will pay more than they would for cap-weighted strategies and there will be tracking errors against cap-weighted indexes for better or worse. 

I don’t know if smart beta strategies will work in the long term. I do know it can’t work if your client’s resolve isn’t strong. So give pause when the mind becomes greedy because the soul seeks prudence.

Investment Planning