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‘Smart beta’ indexed ETFs sure attract a lot of dumb money

As an investment product, “smart beta” is a runaway success. But as an actual investment, smart beta is setting up clueless investors for a possibly rude awakening.

Don’t get me wrong. Many smart beta indexes and the funds linked to them are downright ingenious. While some are complicated or not transparent in their methodology, they can offer low-cost indexed entries into investment strategies that once were exclusive to active money managers and their expensive analysts.

The problem is that smart beta has evolved into a euphemism for “beat the market.” This attracts a lot of salivating performance-chasers. More come along in hope that investing in smart beta somehow makes them smart, too.

The “beta” in smart beta refers to market-generated returns (“alpha” being above-market returns). Accordingly, smart beta originally meant redefining “the market” to be something other than standard compilations of stocks weighted by market capitalization. Different stock selection and weighting were smart beta hallmarks.

But as the term gained marketing cachet, its meaning became stretched so far that nowadays all sorts of things are being pitched under this label. Some lists of smart beta products even include standard growth and value indexes and funds. They qualify for stock selection but not for weighting if they are market-cap weighted.

Here are some examples of index-based ETFs that are, and are not, true “smart beta:”

  • GuggenheimS&P 500 Equal Weight ETF RSP, +0.17% is not because while the weighting is different it is composed of the same stocks that are in the regular S&P 500 SPX, +0.10% .
  • PowerShares FTSE RAFI US 1000 Portfolio PRF, +0.10% qualifies because its stocks are selected and weighted based on four fundamental measures: book value, cash flow, sales and dividends.
  • iShares Select Dividend DVY, +0.56% is “smart beta” because its stocks are selected based on sustained dividend payments and are weighted by the size of the dividend payouts relative to other index components.
  • Schwab US Dividend Equity SCHD, +0.31% doesn’t qualify because its components — selected by 10-year dividend histories and stringent financial ratios—are market-cap weighted.
  • A seemingly new and different perspective can turn out to be exactly wrong.

    There are two reasons for insisting that both stock selection and weighting be nonstandard. First, a lot fewer ETFs meet both conditions, meaning investors have less to sort through in making decisions. And it steers investors away from old wine in new smart-beta bottles.

    Second, it takes altering both pillars of index construction to achieve the essential purpose of smart beta — namely to present an entirely different perspective on the market and therefore how to invest in it. The payoffs are supposed to be improved returns, less risk or both.

    Or none of the above, which sometimes happens. Smart beta isn’t smart enough to overcome all the vicissitudes of the market. A seemingly new and different perspective can turn out to be exactly wrong, even though it looked like a winner in back-testing. With smart beta, as any other investment, you pay your money and take your chances.

    Some of these offerings are beating their benchmarks handily. PowerShares Dynamic Pharmaceuticals Portfolio ETF PJP, -0.26% , for example, uses a “quant” methodology to select and weight 25 pharmaceutical stocks based on fundamental and risk factors. This year through July the ETF gained 22.6%. versus 20% for rival iShares U.S. Pharmaceuticals ETF IHE, -0.10% .

    And some are not doing so well. For instance, PowerShares Dynamic Biotechnology & Genome Portfolio ETF PBE, +0.80% selects 30 stocks with fundamental and technical factors and weights them in a tiered equal-weighting system. It gained 18.5% this year through July, while the iShares Nasdaq Biotechnology ETF IBB, +0.81% shot up 26%.

    Trying to figure when smart beta might hit the sweet spot is no likelier to succeed than trying to time the market with broad benchmark ETFs. Timing is a no-no for indexed investors, who accept their inability to do it consistently.

    So, how does smart beta fit into an indexed investor’s portfolio?

    Make this strategy the “explore” part of your holdings, maybe 10% or so, while you maintain the bulk of your assets in “core” asset-class benchmarks. Use this exploration to fine-tune your core, such as adding more income, or reducing volatility or overweighting something temporarily (such as pharmaceuticals this year, for example).

    Don’t shop the whole gamut of smart beta products. Rather, have a specific purpose in mind and then choose from among those that promise to fulfill it. Buy into your choice with dampened expectations. Over time you will learn what works for you and what doesn’t — and that’s a smart way to stay ahead of the game.

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