Many investors view indexing as representing a market or a slice of a market, and use indexing strategies that are market-cap weighted to capture exposure to these segments of the investable universe. In some circles, however, the concept of indexing has expanded recently beyond these traditional market-cap-weighted boundaries to what some call "smart beta." But investors should be careful to discern smart beta strategies for what they are. Vanguard believes they are active bets, and not substitutes for traditional index funds.
Smart beta explained
According to Joel Dickson, a senior strategist in Vanguard Investment Strategy Group, indexing strategies have evolved greatly. There are many new indexes that have increased variability in weighting methods and produced narrower subsegments. But these developments don't mean that indexing should morph into a different concept.
Smart beta or so-called alternative indexing strategies are any kind of an index that follows an alternative method to the traditional way of market-cap weighting. "These strategies usually try to optimize exposure to specific market characteristics or factors and are riding the coattails of two big investing trends," Mr. Dickson said. "ETFs and indexing are growing rapidly and many investment providers want to be part of these trends. So they have repackaged active investments into a product that tracks an index."
Alternative indexing strategies come in many forms. Some common examples include:
- Equal-weighted strategies. These strategies give an identical static weighting to each security, so that every stock in the targeted index has the same impact on returns. Compared with a cap-weighted portfolio, an equal-weighted portfolio will be more heavily concentrated in smaller companies and, to some extent, in companies trading at low prices relative to their book values.
- Dividend-weighted strategies. Investment providers are offering strategies that weight stocks based on current or expected dividend payments. These strategies can differ significantly from market-weighted indexes. Because companies that pay dividends tend to be larger and have value traits, dividend-weighted strategies tend to overweight the large-cap value segment of the market.
- Valuation-metric strategies. Another approach is to weight companies based on financial valuation returns, such as earnings, revenue, assets, and book value of equity. The performance attributes of these strategies often demonstrate clear size and style tilts toward smaller-cap and value-oriented stocks.
- Alternative fixed income indexing strategies. Common alternative-weighting criteria for fixed income include gross domestic product, population, and other macroeconomic measures for sovereign debt and assets, revenue, and other financial statement metrics for corporate issuers. These strategies tend to favor countries and companies with lower debt ratios.
Practical implications for investors
Because of the different exposures that smart beta strategies offer compared with those of traditional market-cap-weighted indexes, Mr. Dickson said investors should evaluate these investment options as active strategies.
"What most investors expect when they buy an index is that they'll own the market," he said. "However, a rules-based, non-market-cap-weighted strategy doesn't give you the kind of exposure to broad market segments that investors expect. With these strategies, you're in fact making a bet against the market or some segment of the market."
Smart beta strategies can amplify some of the investing risks that have historically been lower for market-cap-weighted index funds, including:
- Strategies not performing as well in the future as they have in the past. In general, alternative indexing strategies available today tend to be biased in favor of small-cap and value strategies. While small-cap and value stocks have outperformed the broad market over the past 15 years, both have gone through extended periods of underperformance, which begs the question, Will investors remain committed to these strategies once they begin to underperform?
- Higher turnover may mean higher transaction costs. The difference in turnover between market-cap and alternative-weighted indexes can be significant. According to Mr. Dickson, it's not unusual for turnover rates of smart beta strategies to be more than double those of broad market-cap-weighted indexing strategies. And the differences can be even more pronounced when comparing the turnover rates of equal-weighted indexing strategies with those of broad market-cap indexing strategies.1
- The challenges of using back-tested data. Many smart beta strategies are based on back-tested data or retroactively applying methodologies to the historical data as if the indexes had existed previously. Mr. Dickson suggested that, on average, back-tested performance doesn't appear to persist past the date an index is first published to the public.2 This is possibly because benchmarks are often chosen for new products based on their attractive past performance history.
Unlike a market-cap-weighted approach, Mr. Dickson pointed out that none of these so-called smart beta strategies will allow you to own the market. As a result, their returns may tend to deviate much more from the return of the broad market than traditional market-cap-weighted index funds, which seek to track the broad market, not beat it. Cost is also a factor: You may pay more than you would in a cap-weighted index fund. "Without such an understanding of these differences, investors run the risk of selecting an investment that doesn't fit their needs or objectives," he said.
An alternative to higher-cost active?
According to John Ameriks, who heads the Active Equity Group within Vanguard Equity Investment Group (EIG), the emergence of alternative-weighting strategies is simply a new marketing strategy for selling "active risk" to investors. However, unlike traditional active strategies, the decision to deviate from the cap-weighted benchmark occurs once at the beginning, rather than part of an ongoing process.
"The issues faced by investors considering a rules-based, passive strategy (a "smart beta" strategy) are similar to those faced by investors considering actively managed strategies. This suggests that investors should evaluate them as active investments," Mr. Ameriks said.
In particular, smart beta can be a way to replace expensive active managers who are making unimaginative factor bets, according to Mr. Ameriks, who added, "In some cases, these strategies can replace a portion of your active portfolio. But it takes a lot of work to know if your strategy will outperform."
As an alternative to smart beta, Mr. Ameriks recommended low-cost active quantitative strategies similar to those he and his EIG investment team manage. "What we do in EIG, and have done since we started running quantitative strategies in 1991, is put together portfolios where we think carefully not just about factor exposure, but how factors interact with one another over time," he said.
Mr. Dickson noted that if an investor wants to overweight or underweight certain risk attributes relative to the market, one low-cost, transparent way to do this can be through traditional cap-weighted indexes. "If you want to increase your exposure to mid-cap value, for example, you could overweight this segment of the market by simply buying the mid-cap value index fund and adding it to your broad-based market index fund," he said. "This approach may allow investors to more specifically target individual risk exposures that they would like to include in their portfolios."
According to Mr. Ameriks, the key point to remember is that while a smart beta strategy seeks to track an index, the index it tracks represents an actively managed strategy. "With this type of index construction, you're essentially saying you believe there are certain types of securities that are mispriced by market participants. I believe that is the very definition of an active bet." he said.
1 Based on Morningstar data of 190 U.S. equity index ETFs (excluding sector funds and weighted by assets), the average annual portfolio turnover ratio for market-cap weighted strategies is 13.5%. In comparison, non-market- cap-weighted strategies, on average, have higher turnover. For strategies that are weighted according to fundamental metrics such as dividends or revenue, the average turnover ratio is 28.7%. And for equal-weighted strategies, the average turnover ratio of 56.6% is even higher.
2 In their research paper, Joined at the hip: ETF and index development, Mr. Dickson and two of his colleagues at Vanguard Investment Strategy Group measured the performance of 370 indexes with back-filled performance against the total U.S. stock market. They found that while the average for all indexes outperformed the broad stock market at an annualized rate of 10.31% as measured by five years of back-filled data, it underperformed at an annualized rate of -0.93% over the five years following the index live date.
- All investing is subject to risk, including the possible loss of the money you invest.
- Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks.
- Past performance does not guarantee future returns.