Investors seem to have lost some of their desire for smart beta, judging by money flows.
Smart beta exchange traded funds and open-end mutual funds took in a net $32.67 billion this year through August 30. That was less than a third of the $109.21 billion they garnered in the same period of 2017.
To be sure, the percentage drop was even bigger for other ETFs and mutual funds, as investors have shunned risk in general. But smart beta funds aren’t supposed to be like other funds; used correctly, they’re meant to improve risk-adjusted returns over traditional index funds by tilting the weight of their portfolios according to various factors, including value, size, price momentum and volatility. So-called smart beta funds have attracted some $1 trillion in total assets. But mediocre performance has recently dampened the enthusiasm.
“Over the last few years, there was a lot of optimism that this is the holy grail,” says Karim Ahamed, an investment advisor at HPM Partners. But now, “people are starting to ask questions.” His firm is testing the smart beta strategy with limited allocations, in case it doesn’t work out.
And indeed their performance hasn’t exactly shot the lights out. Investment research firm Morningstar counted 804 smart beta funds (711 ETFs and 93 open-end mutual funds) as of Aug. 30. Their average annualized return was 14.19 percent over 1 year, 11.20 percent for 3 years, 9.14 percent for 5 years and 8.08 percent for 10 years. That lagged the S&P 500 for each of those time periods—20.32 percent, 15.78 percent, 14.52 percent and 10.86 percent, respectively.
Of course, one could argue that it’s unfair to compare returns to the S&P 500, because many smart beta funds are based on other indexes. But some studies show that smart beta hasn’t performed so well on that score either.
According to research from UBS Group, only 32 to 39 percent of the 560 smart beta funds it tracked beat the performance of each fund’s closest capitalization-weighted index during the 10 years ended April 30, 2017. The numbers were even worse on a risk-adjusted basis, with smart beta outperforming only 25 to 32 percent of the time.
“Lagging performance is the primary problem for smart-beta,” says Jack Ablin, chief investment officer for Cresset Wealth Management. “I’ve been skeptical of small-beta strategies because they tend to optimistically back-test and present their returns in that context. My first reaction is that’s yesterday’s news and not tomorrow’s.”
Smart beta defenders say much of the poor performance of smart beta stems from the fact that a large portion of the funds are tilted toward value stocks, and value has underperformed growth for more than 10 years.
That has to turn around eventually, some argue. “You can’t expect growth to continue outperforming,” says Tom Fredrickson, a New York City financial advisor who’s part of the Garrett Planning Network. He and others note that studies show value ultimately outperforms in the very long term.
Many experts say using a combination of factors produces better risk-adjusted returns, helping to dampen volatility. “Individual factors have unique investment cycles,” says Ben Johnson, director of ETF research at Morningstar. “Using them in combination will increase the likelihood of investors putting them to good use. Factors go better together.”
He puts an interesting classification on smart beta. “At its core, smart beta is just a new form of active management,” he says. “In many ways, it’s a potential improvement upon the prior version of active stock selection. But it won’t defy the laws of gravity that limit active managers overall.”
On the plus side, smart beta’s index approach often means lower expenses compared to traditional active management, Johnson points out. Smart beta, open-end mutual funds and ETFs have an average expense ratio of 0.53 percent, exactly half the ratio for open-end mutual funds and ETFs as a whole, according to Morningstar.
“Smart-beta funds also eliminate an important source of risk that’s present when you have a flesh and blood stock picker: management risk,” Johnson says. “You are outsourcing management to a set of rules that define an index, as opposed to people that have touch, lose touch or fall out touch. Managers can pick up their marbles and go down the street or lose their marbles entirely.”
But there’s obviously no guarantee of success for smart beta, as the lagging returns show. “At the end of the day, it’s still active management,” Johnson says. “Whether it’s U.S. stocks or large caps or small caps, it’s not enough to be different, you have to be good. Some strategies have proven their mettle, and others haven’t.”
Advisors can provide a tilt to clients’ portfolios without the use of smart beta funds, Fredrickson explains. He uses the Vanguard Small-Cap Value Index Fund (VISVX) and the Vanguard Small-Cap Value ETF (VBR) to give clients exposure in that area.
If you’re looking for a smart beta ETF, HPM has clients in the iShares Edge MSCI Multifactor USA ETF (LRGF).
But experts say it will be difficult to make a definitive judgment on smart beta funds, many of which are less than 10 years old, until they are tested by a bear market. “Having been a Wall Street customer for 30 years, I always approach new products with suspicion of whether it’s science or marketing,” Ablin says. “With smart beta, it’s hard to tell.”