Can These Hot Passive ETFs Keep Topping the Benchmarks?

TheStreet.com

NEW YORK (TheStreet) -- Stocks have provided rich rewards since the financial crisis. During the past five years, SPDR S&P 500 returned 16.5% annually, according to Morningstar. But you could have done even better with ETFs that weight stocks in less traditional ways. Guggenheim S&P 500 Equal Weight returned 19.9%, and PowerShares FTSE RAFI US 1000 , which weights stocks according to fundamental measures, returned 19.6%. Other promising approaches include funds that emphasize stocks with low-volatility or momentum. Often called smart beta benchmarks, the alternative approaches have come to be seen as ways to outdo the traditional measures such as the S&P 500.

Among the leading proponents of smart beta strategies is Rob Arnott, chairman of Research Affiliates, the developer of the RAFI benchmarks. In recent research, Arnott looked at how half a dozen smart beta strategies would have performed over the last 50 years. All the strategies topped traditional benchmarks. The high-volatility approach outdid the S&P 500 by two percentage points annually. Low volatility fared even better.

Arnott concluded that the traditional benchmarks trail because they weight stocks according to market capitalization. Under that weighting system, Apple -- the biggest stock in the S&P 500 -- accounts for 2.8% of the assets in the index, while Abercrombie & Fitch accounts for 0.03. When a hot stock rises, it will account for a bigger weighting in the S&P 500. "The notion of giving more weight to rising stocks seems to be wrong," Arnott said, speaking at the recent Morningstar ETF Invest Conference in Chicago.

The hazards of market-cap weighting became clear during the bull market of the late 1990s as technology stocks soared and dominated the benchmark. After the Internet stocks collapsed in 2000, S&P 500 index funds sank hard. Arnott claims that smart beta benchmarks deliver better results because they don't keep piling assets into the hottest stocks. Instead, the alternative strategies weight stocks by measures such as sales or volatility, which don't always rise and fall with stock prices.

But not everyone has been persuaded by the recent winning streaks of some smart beta funds. Vanguard Group, which has long championed traditional index funds, argues that market-cap weighting represents the best approach for passive investors. According to the Vanguard view, the prices of stocks represent their fair values at any given time. Smart beta systems are engaging in a form of active management, betting that some stocks are undervalued. While smart beta funds have excelled during some years, at other times the approaches have lagged for long periods.

In a recent report, Vanguard pointed to the S&P 500 equal-weight index as an example of a benchmark that is placing a clear bet. The equal-weight system puts about 0.2% of assets in each of the 500 stocks. In effect, the biggest stocks are underweighted, while the smaller stocks have a greater weighting than they receive in the standard benchmark. In the past decade, the equal-weight approach has succeeded because mid-cap stocks have outdone large ones. But there is no guarantee that large stocks will not lead the parade in the coming 10 years.

Besides underweighting large stocks, the equal-weight benchmark also gives limited exposure to the hottest growth stocks, which have high share prices. This results in a bias to value stocks. Many academic studies have shown that value stocks tend to outperform over long periods. But there are often periods of five or ten years when growth leads the markets.

Like the equal-weight funds, the other smart beta strategies tend to tilt toward small and value stocks. Vanguard concedes that there may be legitimate reasons for investors to tilt portfolios, but the company argues that the smart beta funds can be more expensive than traditional index funds. Investors who want to tilt their portfolios can accomplish the goal with standard mutual funds, says Joel Dickson, a senior investment strategist for Vanguard.

Dickson says that an investor who wants to emphasize midcap stocks could hold an equal-weighted S&P 500 fund or a standard market-cap weighted midcap fund. While both choices have similar characteristics, the midcap fund is a bit more volatile. According to Morningstar, the equal-weight fund has 54% of assets in large-cap stocks and 45% in midcaps. "The equal-weight index is technically a large-cap portfolio, but the behavior is similar to a portfolio of stocks with market caps of $5 billion to $15 billion," says Dickson.

During the past ten years Guggenheim S&P 500 Equal Weight returned 9.3% annually, while Vanguard Mid Cap Index returned 10.1%. The Vanguard fund charges an expense ratio of 0.08%, compared to 0.40% for the equal-weight fund.

Proponents of the smart beta funds concede that their strategies do tilt to small and value stocks, but they say that equal-weighting and the other approaches have an advantage because of the way they rebalance. Under the equal-weight system, the weighting of each stock must be held constant and rebalanced quarterly. If a stock soars, then the portfolio manager must trim it at the end of the quarter in order to maintain the equal weighting. At the same time, the manager must buy more shares of losing stocks. In effect, the equal-weight index is constantly buying cheap stocks and selling expensive ones. That is a recipe for long-term success, advocates argue.

Will the smart beta choices outdo the traditional benchmarks over the long term? That's impossible to know. But chances are that low-cost ETFs following both approaches will deliver strong returns for patient investors.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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