Smart-beta funds get mixed reviews in first quarter

Smart-beta exchange-traded funds, which use rules from active management to guide their securities selection, have been the hottest product in the industry. So how did they do in the first quarter, one of the most volatile quarters in years?

It’s a mixed record, but a few did shine through.

The Standard & Poor’s 500 stock index fell 0.76% through Thursday, including reinvested dividends, according to Morningstar Inc. But it was a rocky ride: The blue-chip index soared 7.55% through Jan. 26, then tumbled 6.63% on fears of trade wars and worries about some of the biggest technology companies in the nation — most notably, Facebook.

Morningstar counts 696 smart-beta funds, which it calls “strategic beta funds.” Whatever you call them, there are vast differences between them: 512 are classified as return-oriented, which means they attempt to beat a particular index via rules-based stock selection. Another 42 are risk-oriented, meaning they attempt to reduce risk in some way. (The remaining smart-beta ETFs are classified as “other.”)

Let’s start with the return-oriented group, which also has the largest funds by assets. The most popular funds are “smart beta 1.0,” which use only one factor, such as growth or value. The biggest smart-beta fund, the $76.6 billion Vanguard Growth ETF (VUG), has risen 1.19% since the start of the year. The second-largest, the $65.2 billion Vanguard Value ETF (VTV), fell 2.28%.

Even with those simple divisions, there can be considerable differences, said Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. For example, while Vanguard Growth ETF (VUG) rose in the first quarter, iShares S&P 500 Growth ETF (IVW) rose 1.88%.

“Your mood is a lot better if you’re up 1.88% than if you’re up 1.19%,” Mr. Rosenbluth said.

Funds that use dividends as a factor, such as those that look for stocks with a continuous record of raising dividends, generally disappointed — the average dividend-weighted fund fell 2.50% in the first quarter, according to Morningstar.

“Dividend strategies lagged as bond yields moved higher,” Mr. Rosenbluth said.

The top-performing dividend strategic beta fund was SPDR S&P Emerging Markets Dividend ETF (EDIV), which rode the tide of emerging markets stocks to a 6.37% gain.

The same proved true even for technology stocks. First Trust NASDAQ Technology Dividend ETF (TDIV), which invests only in dividend-paying tech stocks, would have avoided first-quarter bombs like Facebook and Google. The ETF gained just 2.27% in the first quarter, versus 5.02% for tech funds in general. And one of the worst-performing return-oriented funds, PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD) combined high dividends and low volatility to lose 6.02% for the quarter.

A few multifactor return-oriented funds stood out, typically those that use growth or momentum strategies.

For example, First Trust Large Cap Growth AlphaDEX ETF (FTC), gained 3.91% in the first quarter, while Alpha Architect US Quantitative Momentum ETF (QMOM) gained 4.18%.

Risk-oriented smart-beta ETFs had similarly mixed results, although traditional risk-reduction strategies, such as seeking stocks with low volatility, lagged the S&P in general — largely because those stocks tend to pay high dividends.

But that’s no reason to dismiss them, said Alex Bryan, director of passive strategy research at Morningstar. “The ones that have been around for a while generally offer lower downside capture,” he said. “That’s not to say that they will perform well every day, but over the long term, they have performed about as you would expect.”