The “smart-beta movement” in ETFs has gone from a sideshow to a juggernaut in recent years. We’ve seen a rash of new issuers, strong net inflows and advisors of all sorts adding smart-beta exposure to their portfolios.
The predictions for future growth are extreme. In May of this year, BlackRock predicted that smart-beta ETF assets would reach $1 trillion by 2020 from their current level of $282 billion. That’s a 37% compound annual growth rate over four years. The amazing thing is, hardly anyone flinched at the number.
But the growth of smart-beta strategies in the ETF market is hardly new. ETF.com Editor-in-Chief Drew Voros asked me to identify “fewer than 10” ETFs that charted the course of smart-beta growth since the industry’s inception. And while that’s an impossible task—there are at least 20 deserving candidates—I agreed to describe nine among that list that are deserving.
Smart-Beta ETF No. 1: iShares Russell 1000 Value ETF (IWD | A-88)
AUM: $29 Billion
Expense Ratio: 0.20%
Why: Among The First Real Smart-Beta ETFs
People argue about what does and does not constitute a smart-beta ETF. To my mind, there’s a (slim) argument to be made that the very first ETF—the S&P 500 SPDR (SPY | A-97)—is a smart-beta ETF. After all, the origins of smart-beta investing trace their roots back to the work of Fama and French, who first argued that the returns of a stock could be explained by its exposure to three factors: 1) the market; 2) the size factor (large- versus small- cap stocks); and 3) the value factor (price-to-book ratio). As a large-cap ETF, SPY takes deliberate exposure to large-cap stocks.
That kind of argument can get you laughed out of Quantitative Work Alliance for Applied Finance, Education, and Wisdom discussions, however, as most investors use SPY as a proxy for “the market.” That leaves us with the iShares Russell 1000 Value ETF (IWD | A-88), which launched in May 2000 and is among the first ETFs with deliberate exposure to the value factor. While value isn’t as hip as nouveau factors like “low volatility,” it’s perhaps the most consistent and established factor for investors looking for long-term excess returns.
Consider this: Since inception, IWD has outperformed the iShares Russell 1000 ETF (IWB | A-94) by about 60%. Pretty smart indeed.
Smart-Beta ETF No. 2: PowerShares Dynamic Market Portfolio (PWC)
AUM: $141 Million
Why: Proved ETF Investors Want To Beat The Market
While IWD was among the first, the PowerShares Dynamic Market Portfolio (PWC | B-73) is, to my mind, one of the most groundbreaking ETFs in the evolution of smart beta.
Prior to the launch of PWC in 2003, ETFs were about tracking the market. Funds like SPY were used to equitize cash and gain exposure; they were, as people might call them today, “dumb beta.”
PWC promised something different. With a bold 0.60% expense ratio, PWC shocked the world by promising to beat the market, using a multifactor model to flesh out the stocks that would outperform.
And for a while, it worked. The fund easily surpassed its market-cap peers in the first few years after inception, earning a five-star rating from Morningstar at its three-year anniversary. At that point, it led the market by 7% since inception.
Big assets followed into both PWC and the broader PowerShares suite, which pulled in more than $6 billion in its first three years on the market. And while the fund’s performance eventually tailed off—it now trail20s the S&P 500 since inception—PWC’s success put PowerShares on the map, and proved outperformance could be sold in the ETF space just as it was in mutual funds. That realization launched a thousand more ETFs, and set the stage for the boom we see today.
Smart-Beta ETF No. 3: Guggenheim S&P 500 Equal Weight ETF (RSP)
AUM: $9.91 billion
Why: Smart-Beta ETF Bought By People Who Might Not Love Smart Beta
The Guggenheim S&P 500 Equal Weight ETF (RSP | A-79) is an odd bird. It’s not really “smart”—the fund simply holds an equally weighted exposure to each stock in the S&P 500 and rebalances quarterly. There is no intentional factor bet, although it certainly skews toward small- and midcaps. It doesn’t necessarily have an elaborate academic theory behind it, although it preys on the concept of rebalancing and reversion to the mean.
Yet RSP has come to hold a special place in investors’ hearts. It is large, extraordinarily liquid, and owned by a large number of investors who ordinarily wouldn’t own a smart-beta ETF.
I speak with a lot of investors about why they own smart-beta ETFs, and they usually trail off about the theory behind the ETF. But with RSP, they just like it. They like that it buys low and sells high, and they tend to rotate into it when the market is ripping. It belongs on this list if for no other reason than it broadens the tent of people who consider themselves in the smart-beta game.
Smart-Beta ETF No. 4: iShares Dow Jones Select Dividend Index Fund (DVY)
AUM: $16.26 Billion
Inception Date: 11/3/03
Why: Packaged Dividends Into ETFs; Married The Old And The New
People like to think that “smart beta” is a new idea, but the truth is that investors have been looking for factors and strategies that can beat the market since the dawn of investing. Take dividends.
Dividends have been considered one of the keys to strong performance since … well, forever. Legendary value investor Benjamin Graham wanted to see 20 years of continuous, uninterrupted dividends before he would buy a stock, and significant academic research has shown the value of dividends to long-term returns.
The iShares Dow Jones Select Dividend ETF (DVY | A-67) was the first ETF to make capturing dividends an explicit goal. Successful out of the gate, DVY spawned an entire industry of dividend-capturing ETFs, marrying the latest fund technology with the oldest investment philosophy on the books. Tens of billions of dollars have followed.
Smart-Beta ETF No. 5: PowerShares FTSE RAFI US 1000 Portfolio (PRF)
AUM: $4.28 Billion
Inception Date: 12/19/05
Why: Backed by Rob Arnott's Academic Efforts And Aggressive Promotion, This ETF Jump-Started The Era Of Modern Smart-Beta Investing
As important as value and dividends funds were in the evolution of smart beta, the PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-85) probably signals the kickoff of the current smart-beta vogue.
The fund was the first ETF to track an index developed by Rob Arnott’s Research Affiliates. Arnott is an academic practitioner whose Financial Analysts Journal article, “Fundamental Indexation,” threw down the gauntlet against market-cap-weighted portfolios. Published in early 2005, the article laid out a convincing case against traditional indexing, suggesting it systematically overweighted the most overvalued components in an index.
Arnott championed this theory aggressively to financial advisors and institutional investors alike, and got folks thinking about the potential shortcomings of traditional indexes. Sometimes referred to as the “godfather of smart beta,” Arnott’s efforts helped pave the way for the boom that followed. PRF was his first big entry into the ETF market.
Smart-Beta ETF No. 6: WisdomTree MidCap Dividend ETF (DON)
AUM: $2.0 Billion
Inception Date: 6/16/2006
Why: Introduced Idea Of Replacing All Exposure With Smart-Beta ETFs
WisdomTree burst onto the ETF scene in 2006 by launching 20 different ETFs united by a common, alternative weighting methodology. Specifically, its funds focused on weighting stocks by their contribution to the dividend stream rather than their market capitalization.
By launching a full suite of products, WisdomTree challenged investors to put smart-beta-style ETFs at their core of their portfolios. After all, it’s one thing to add a dividend-weighted fund to the “explore” portion of your portfolio, and quite another to replace all of your core with a dividend-weighted methodology.
I’ve included the WisdomTree Mid Cap Dividend ETF (DON | A-100) here simply because it’s currently one of the largest of the 20 original ETFs launched by WisdomTree; the recognition should really go to the full suite.
Smart-Beta ETF No. 7: First Trust Consumer Discretionary AlphaDex Fund (FXD)
AUM: $1.8 billion
Inception Date: 5/8/2007
WHY: By Investing For The Long Term Of Its ETF Business, First Trust Proved You Can Build Real Traction If You Wait For The Performance To Come
First Trust is unique in the ETF space, but it’s played a critical role in the development of the smart-beta market. It came to market first in 2006 and in earnest in 2007, deploying a large swath of ETFs based on an “AlphaDex” methodology that was one of the most complete, multifactor methodologies launched at the time.
First Trust deserves a call-out in this history for three reasons. First, the company launched a wide swath of funds and then stuck things out. Even when the funds didn’t attract much in the way of assets in the first few years, the firm didn’t pack it in and close up shop; they waited, patiently, until the funds delivered a strong run of performance, and then they sold them aggressively to advisors. Secondly, the firm’s early partnership with Dorsey, Wright & Associates created a series of model portfolios that helped jump-start the “ETF strategist” phase. And finally, by offering an array of ETFs that appealed to investors who previously loved picking actively managed funds, it significantly widened the list of advisors who considered ETFs.
Smart-Beta ETF #8: PowerShares S&P 500 Low Volatility ETF (SPLV)
AUM: $8 Billion
Inception Date: 5/5/2011
Why: Brought Single-Factor Exposure Into Vogue
The PowerShares S&P 500 Low Volatility ETF (SPLV | A-70) wasn’t the first ETF to target low-volatility exposure; that recognition goes to a now-defunct ETF from Russell Investments. But SPLV was the first to catch fire, capitalizing on the so-called low-vol anomaly: The finding, borrowed from academia, was that stocks with lower volatility seem to have higher long-term returns than stocks that bounce around a lot.
This remarkable combination attracted a flock of investors who quickly pushed assets into the billions. In so doing, SPLV broke the mold of old-school factors like value and dividends, and pushed us all into the modern era of low volatility, quality, momentum investing and more. Still a popular fund, it truly started a trend.
Smart-Beta ETF No. 9: Goldman Sachs ActiveBeta Large Cap ETF (GSLC)
AUM: $741 Million
Inception Date: 9/21/15
Why: Introduced The Smart Beta World To The Concept of Price War
The newest ETF on the list, the Goldman Sachs ActiveBeta Large Cap ETF (GSLC), is important for a variety of reasons. For starters, its success—pulling in $736 million in its first 10 months on the market—proved once again that newcomers to the ETF space could pull down significant assets if they put the right brand, distribution network and product strategy in place. Secondly, it heralded the launch of another blue-chip Wall Street firm into the ETF space. But most importantly, and the reason for its place on this list, was that it priced at an expense ratio of 0.09%.
Expense ratios in ETFs have been under pressure since 1993, and the smart-beta space has not been immune. But GSLC took things to an entirely different level by pricing itself competitively with the cheapest ETFs in the world. Indeed, GSLC is priced exactly the same as the S&P 500 SPDRs (SPY|A-97), challenging people with the question: Do you want basic large-cap exposure or do you want exposure managed by some of the smartest people on Wall Street?
It’s an important question that’s resonated throughout the smart-beta space.
Wide Variety Of Important Funds
Any list is going to omit a variety of equally deserving funds: multifactor ETFs from State Street Global Advisors, funds like the FlexShares Credit-Scored US Corporate Bond Index Fund (SKOR | B) that have opened up smart beta in the fixed-income space, and products like the VanEck Vectors Morningstar Wide Moat ETF (MOAT | A-63) that have broadened the definition of what smart beta is, all deserve nods.
Perhaps the most defining feature of the smart-beta boom is the heterogeneity. Smart beta can mean many different things to many different people. And that’s probably the most definitive thing about this list: When we look back on this list in 10 years, there will be many more funds and many more assets between them.
At the time of writing, the author owned none of the ETFs mentioned. Matt Hougan is the CEO of InsideETFs and can be reached at firstname.lastname@example.org.