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Don’t Let Growth Of Smart Beta ETFs Blind You

If you mention the words “alpha” or “beta” to someone outside the financial service industry, they’d probably think you’re referring to the first two letters of the Greek alphabet. That would’ve included me before I arrived at ETF.com more than five years ago.

But it didn’t take me long to learn that these two words are among the most important in the financial services industry, and it had nothing to do with the Greek alphabet.

Are you satisfied with broad market returns (beta), or do you seek to outperform the market by hunting down winners in the financial forest (alpha)? It’s a fairly simple concept, even if you don’t know anything about the financial world.

A Simple Smart-Beta Definition

But then a few years ago, a new term began cropping up more and more: “smart beta.” Like any new terms for products that are being sold, the moniker was met with skepticism that this was merely a marketing gimmick offering both alpha and beta in one—if it could only be that easy.

It wasn’t a gimmick; rather, a term that spoke to the structure of the fund and how it selected underlying securities.

Here at ETF.com, we define and screen smart-beta ETFs by the following simple criteria (see our Smart Beta Guide):

“The broadest, most practical definition is probably this: any index-based strategy that either chooses securities or weights securities for an intentional reason other than their market capitalization, geography or sector classification.”

You can fill a financial conference (Inside Smart Beta) debating that definition, but we’re comfortable with ours. These products “are not your father’s beta Buick” would be a good marketing motto, in my book.

Real Money In Smart-Beta ETF Space

However you define it may be debatable, but smart beta’s success in the ETF space is undeniable. Using ETF.com’s smart-beta screener shows there are 763 smart-beta funds holding some $525 billion in assets under management. The average expense ratio for all of these funds is approximately 0.56%. Do a little math and that comes to roughly $3 billion in annual revenues for ETF issuers from these types of funds.

And smart beta is a growth business as well, with the category leading in launches. More than half the some-150 launches this year were smart-beat funds, with a full pipeline-load more in the regulatory approval process.

Some of the biggest names in the financial world have jumped into the ETF pool for the first time with smart-beta swim trunks, while longstanding ETF stalwarts like iShares and others have developed an extensive suite of funds incorporating single factors or combining them in multifactor funds.

So where does the trend go from here? As they say on Wall Street, the trend is your friend, and in the business sense, there will be growth in both products and revenue for issuers.

A bigger unknown is whether the proliferation of using factors, fundamentals or alternative weights of any sort in fund construction will start diluting the promised alpha. When these alternative approaches become more and more mainstream, will the outcome for these different approaches become more similar?

Potential To Overthink

Where future growth for smart beta comes from, and what happens to the factors as they become more widely embraced, were part of the discussions at the Inside Smart Beta conference in New York last week that I and hundreds of others attended.

There seemed to be some agreement that growth in this large corner of the ETF market will continue as more money leaves expensive and underperforming active management for these factor and fundamental products. But I would also hope investors don’t overthink this.

Whether this is a better mousetrap for capturing returns is unclear. There are so many different ways that factors and weightings are being used that it would be nearly impossible to have a concrete statement on outperformance versus market benchmarks, like the S&P 500.

But I gave it a shot using the 10 biggest smart-beta funds, as defined above. I then charted them over the last three years, and came up with the four-best-performing smart-beta funds from that group. Those funds were the iShares Russell 1000 Growth ETF (IWF), the Vanguard Value Index Fund (VTV), the Vanguard Dividend Appreciation Index Fund (VIG) and the iShares Russell 1000 Value ETF (IWD).

I then compared them with the venerable market benchmark, the SPDR S&P 500 ETF Trust (SPY), over the last three years.

Chart courtesy of StockCharts.com

SPY holds its own with only one ETF—IWF—outperforming it over that time period. The point of this exercise is to highlight that investors shouldn’t view SPY or the Vanguard S&P 500 Index Fund (VOO) or the iShares Core S&P 500 ETF (IVV) as something that’s outdated or not performing.

In fact, broad market funds, if nothing else, offer investors a simple thesis of owning the market, that, in itself, is also smart.

The beauty of the growing ETF market in the U.S. is not only that investors are seeing new products that might offer better returns, but that some of the tried-and-true products from over the past two decades can also still provide solid returns in a dirt-cheap package. You can have both.

The key is to understand how different products work in a portfolio, and that’s where advisors can help.

Drew Voros can be reached at dvoros@etf.com

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