Smart Beta ETFs: Summing It All Up

by: Dan Bortolotti

This is Part 10 in a series about smart beta ETFs. In this final installment, we review what we've learned and consider the pitfalls of embracing smart beta strategies.

At last we arrive at the final post in this series on smart beta ETFs. From the comments, tweets and few cancelled subscriptions, I know some readers didn't make it this far. Even if you stuck it out, you're probably asking why I've devoted so much space to this technical subject. After all, I've spent years arguing that investors should keep things simple with traditional index funds and ETFs, and let go of the dream there's something better out there. Have I changed my tune and embraced a strategy that strives to beat the market by tilting toward value stocks, small caps, momentum, low volatility and high-quality companies?

Let's be clear: I haven't changed my position. I still recommend plain old cap-weighted ETFs for DIY investors and our full-service clients. I still use them in my own portfolio.

So why devote so much space to smart beta? Because it's the single biggest trend in the ETF world, and it's not going away any time soon. All of the big fund providers - BMO, iShares, even Vanguard - have joined the party, and the smaller ones such as First Asset specialize in these strategies to set themselves apart from the giants. If you're going to use a smart beta strategy successfully, you should go into it with your eyes open. And if you're a traditional index investor - as I hope you are - a thorough understanding of smart beta is the best way to avoid being seduced by its promises.

Before you leap

The previous posts in this series included a lot of information but there were a few recurring themes. Let's review these important ideas before you fill your portfolio with the latest smart beta ETFs.

The premiums may not last. It's not fair to dismiss an investing strategy with a lazy wave of the hand, muttering that "what worked in the past might not work in the future." Some of the factors identified by academics - notably value - have been battle-tested and may well persist, either because they are rewards for assuming higher risk, or because investors have behavioural biases that are unlikely to go away. But others have shorter histories, smaller samples, vague definitions and less compelling explanations. What's more, as these strategies become more widely known and pursued, it seems likely that the premiums will shrink.

Factors are difficult to capture. There are many ways to build an index that targets value, or low volatility, or high quality, and the methodology used by your ETF may have little in common with the ones discussed in the academic research. In other words, even if the factor is real, your ETF may not be capturing it. If you have the time, skill, data and inclination to run regressions on these indexes you may be able to tease out some useful information. But unless you have a master's degree in finance, it's awfully difficult to compare smart beta strategies and choose the most sensible one. Many investors will be tempted to choose the one with the best recent performance, and we all know how that usually turns out.

Outperformance will be reduced by fees, transactions costs and taxes. Cap-weighted indexes aren't perfect, but you should never underestimate the benefit of their rock-bottom costs and reliable tax-efficiency. Many smart beta ETFs carry fees 50 or more basis points higher than traditional index ETFs, and because they're rebalanced semi-annually, quarterly, or even monthly, they're likely to incur higher trading costs and distribute more capital gains. These don't show up in an index's backtested results, but ETF investors in the real world don't have the luxury of ignoring costs and taxes.

Investors are human. There have been many periods of five and even 10 years when stocks underperformed bonds, but most of us remain confident equities will deliver over the long term. I'm not sure investors will have the same conviction when - and it's definitely when, not if - factors like value, size or momentum lag the market over long periods. Investors routinely lose patience when their strategy underperforms for a year or two. Then they jump to another strategy that has enjoyed some recent success, probably just before the music stops.

All investors are prone to bad behaviour, including Couch Potatoes. But I think indexers have a different mindset than those who are attracted to smart beta or active strategies. Index investors are disappointed by low returns, but they don't usually lose faith when markets are weak, because traditional ETFs typically behave exactly as expected. But imagine an investor who buys a low volatility ETF only to watch it not only trail the market for two years, but also underperform a different low volatility ETF from another fund provider. Would she have the same long-term confidence in her strategy?

So, no, I haven't abandoned the Couch Potato: on the contrary, the more deeply I look into smart beta and other alternative strategies, the more convinced I become that simple is still the best solution. If you skipped this series because you found it boring or irrelevant, that's fine: there's nothing wrong with staying within your comfort zone. If you slogged through all 10 posts, I hope you came away with a nuanced understanding of these strategies, which will become more widespread in the coming years.

Either way, I'll leave the last word to Benjamin Graham, who wasn't talking about smart beta, but could have been: "To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."