Read the fine print before plunging into smart beta

Advisers considering diving into smart beta may want to read the fine print before taking the plunge.

Industry observers are warning investors to be cautious before adopting the hottest trend in index investing, which Morningstar Inc. estimates accounted for $1 of every $5 that moved into exchange-traded funds last year.

The definition — and even appropriateness — of the term smart beta is highly contested.

But proponents generally hold the view that financial markets can be beat in predictable ways and that the factors generating long-term outperformance can be boiled down to a set of trading rules that money managers can implement at a fraction of the cost of active management.

In practice, this generally means ditching a traditional index, such as the S&P 500 or Russell 2000, in favor of other indexes that prize other dimensions of a security than its market value, such as low volatility.

In its annual letter outlining its regulatory priorities, the Financial Industry Regulatory Authority Inc. announced a plan to focus on exchange-traded products “tracking alternatively weighted indexes.”

“While back-tested results and some academic research have highlighted the potential efficacy and attractiveness of alternatively weighted indexes, it remains an open question how the indexes and products tracking them will behave in different market environments going forward,” Finra said.

ACADEMIC ROOTS

Acolytes of smart beta-style strategies — from financial advisers endorsed by Dimensional Fund Advisors to devotees of Robert D. Arnott’s Research Affiliates — argue that cap-weighted indexes, such as the S&P 500, allocate too many resources to companies that are likely overvalued.

That over-allocation, they argue, has the effect of eroding the benefits of diversification that are among the primary reasons for using broad-market indexes in the first place.

On their side, the investors argue, are decades of research at the core of academic finance, including the work of Eugene F. Fama, Kenneth R. French and other scholars.

Mr. Fama, who with Mr. French in 1993 first identified the existence of excess returns for equities generally, and small-cap and “value” stocks in particular, won the Nobel Prize in Economic Sciences in 2013.

A range of other factors are said to exist as well, and there’s considerable debate over them. For instance, relatively hard-to-trade, or illiquid, stocks, those with stable prices (low volatility), and those on a winning streak (momentum) are often thought to outperform.

Once investors decide which, if any, factors are worthy of allocation, they face equally weighty questions about how to combine them. Multifactor ap-proaches and equal-weighting are often seen as ways to diversify the risks of each factor.

RISKS

Analysts agree that even a perfectly diversified portfolio will come with risks.

If a factor produced excess returns in the past, there is no guarantee it will continue to do so, particularly as more investors adopt the strategies, according to Scott Kubie, chief investment strategist at CLS Investments, an Omaha, Neb., money manager.

“That long-term outperformance is going to be an interesting factor — to see how durable these are — and that’s something we’re watching closely,” Mr. Kubie said.

The cost of implementing smart beta strategies, including trading costs and management fees, can be higher than the cost of traditional indexes, creating a hurdle that excess returns must at minimum compensate, Finra cautioned.

Other investors prefer to target characteristics such as high dividend payments as they look to amplify yields in their portfolio, according to Elisabeth Kashner, who leads research for ETF.com.

Once an investor decides which market factors are worthy of seeking, he or she faces the task of picking the right index and building a portfolio that does a good job of harvesting those returns.

“A lot of these people look at these funds and they look at their back-tested results, and they get overexcited about that and they don’t look at what’s under the hood,” said Alex Bryan, the lead passive strategies researcher at Morningstar. “Once it goes live, most of that outperformance goes away.”

Mr. Bryan said investors should not necessarily look past traditional indexes that may achieve goals better than “smart beta” strategies that are superior only in theory.

To avoid rotten apples, Mr. Bryan suggested conducting quantitative factor analysis of investment strategies. Statistics mavens can use regression analysis to attempt to isolate portfolios’ sensitivity to market factors and how they compare against traditional benchmarks using publicly available data.

TOOLS CAN HELP

For those without the inclination to run the analysis themselves, tools like portfoliovisualizer.com can simplify the process, allowing advisers to enter a ticker symbol and draw up detailed statistics.

Doing that sort of analysis can yield disappointing results for investors looking to improve upon traditional portfolios.

Ms. Kashner looked at the performance of a number of non-traditional index strategies and found that they failed to deliver results meaningfully different than plain-vanilla counterparts, even when the figures were adjusted to account for exposure to market risk.

Her survey of 11 widely used complex, smart-beta-style strategies in the U.S. large-cap category, published last May, found none that performed statistically differently than their benchmark over one-, three- and five-year periods.

“They’re almost entirely indistinguishable on a risk-adjusted basis from their peers and from other vanilla indexes,” Ms. Kashner said. “The single unifying factor of smart beta is this claim that by applying X, Y, Z set of rules you can improve upon the performance of a cap-weighted index. If you want to live by that definition, therotten you have to be willing to be judged by that definition.”