By Jessica Toonkel
Dec 30 (Reuters) - The fastest-growing segment of the exchange-traded fund market, so-called "smart beta" funds, are sold as index funds but are actively - sometimes frenetically - traded portfolios that can whipsaw investors and often fail to deliver the outsized returns their issuers promote.
Over the last one- and three-year periods, they have on average lagged their plain-vanilla counterparts in almost every category, according to an analysis performed for Reuters by ETF.com, a research firm. Along the way, many have turned over their portfolios two and three times a year and undershot their own specialized benchmarks by significant margins.
Yet they have become a magnet for investor dollars, pulling in 60 cents for every dollar flowing to ETFs over the last two years, according to Morningstar.
ETFs generally track slow-changing traditional indexes, with component stocks represented in proportion to the size of their market capitalization. Smart-beta indexes, in contrast, are weighted by alternative criteria and typically created via algorithms designed for their ability to cherry pick winning stocks.
A so-called smart beta fund, for example, might start with the companies in the Standard & Poor's 500, weed out all without growing dividends and earnings and then hold equal amounts of the remaining stocks.
Issuers call their funds smart beta because they aim to add outsized performance (beta) to plain-vanilla indexes. To be fair, it has been hard for active managers generally to beat indexes during the last three years, when stocks in the S&P 500 have risen at annual rates approaching 20 percent. Many smart beta ETFs are designed to do better in down markets, so they may still have their day.
But individual investors who are sending money to these funds, often at the recommendation of financial advisers, may not understand what they are getting.
"Not all of these strategies are smart," said Ben Johnson, an analyst with Morningstar, which uses the term "strategic beta" when it categorizes these funds.
The ETF.com analysis found that over three years, the typical plain-vanilla fund beat the average smart beta fund in seven of eight categories. Over one year, plain vanilla won six of the eight categories.
The one smart beta category that did outperform plain vanilla over the past three years was the developed market excluding U.S. companies category. But it beat plain vanilla by only .03 percent.
HIGH TURNOVER, HIGH COSTS
All of the fund companies disclose their methodologies in their prospectuses, and firms say they spend a lot of time explaining their methodology to advisers.
But these strategies can get very complex, and very active. For example, the Vident International Equity Index Fund states that it is a risk-weighted portfolio of non-U.S. countries that "promote human productivity." It uses an array of research metrics, such as country debt-to-GDP ratios and taxation rates.
The simple-sounding First Trust Value Line 100 Exchange-Traded Fund, an equally weighted index of 100 U.S. stocks that meet certain price and earnings screens, had a 350 percent portfolio turnover rate in 2013, changing the focus of the fund dramatically. Last year, for example, it had 19.5 percent of its portfolio in financial stocks; this year it is 4.8 percent.
Although all of that activity helped the fund outperform its peers last year, it has underperformed the slow-trading plain-vanilla mid-cap blend funds with which it is compared for the last 3, 5 and 10-year periods, according to Morningstar. It's in the bottom 1 percent of performers over the last 10 years ending Sept. 30, according to Morningstar.
The fund, which tilts toward small and mid-cap companies, tends to do better when small-cap companies outperform large-caps, which we have not seen recently, said Ryan Issakainan, an ETF strategist with First Trust.
All of that trading can cause a fund to be expensive, thanks to higher-than-usual transaction costs.
Perhaps that's why so many of these funds - which have average fees of 0.53 percent of assets a year, compared with 0.47 percent for traditional equity ETFs - are not even matching their own proprietary indexes.
In the past two years, roughly 12 percent of smart beta ETFs trailed their own indexes by more than 1 percentage point, almost double the average expense ratio for the category, according to ETF.com, which looked at daily rolling 12-month periods.
Not all of the strategic funds underperform, of course. Although the Vident ETF, which costs 75 basis points, is lagging its own index substantially - it is down 1.8 percent year to date through Dec. 29, while the Vident International Equity Index is down 0.37 percent - it is beating the plain-vanilla Vanguard Total International Stock ETF - which is down 3.06 over the same period.
Investors in smart beta funds cannot rely on the autopilot approach more passive ETF investors might take.
"The challenge for investors is picking the ones that will outperform, and that is not easy," said Dave Nadig, chief investment officer of ETF.com. "Indexing does not mean passive anymore." (Reporting by Jessica Toonkel; Editing by Linda Stern and Dan Grebler)