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Who Are Smart Beta ETF Funds For?

Posted on: 28.10.2016

A Smart Beta ETF strategy is for the investor seeking to outperform the total market. This new investment strategy that eschews the traditional market-cap weighting style is for those that believe superior value resides in companies with greater fundamentals. Investors engaging in a Smart Beta strategy have a close eye on the granular level, published formulas comprising the fund.

This has a distinct advantage that’s less evident with traditional actively managed funds that are at the whim of a nebulous team of advisors. When you’ve committed to a set plan upfront you’re far less likely to deviate. Smart Beta strategies to have the benefit of countering the problems of behavioral finance.

The emerging field of behavioral finance endeavors to explore the notion that you, the investor, are your own worst enemy. In the past traditional economics has been the tool in understanding how and why business, markets and individuals operate as they do. Today this is changing.

Experts have incorporated cognitive and behavioral psychological theory to more clearly understand why rational decision making can so dramatically breakdown. It is these breakdowns that can cause loss of personal wealth and at it’s worst decimate entire markets. Irrational thinking leads to economic problems.

This automation also allows for lower fees. The February, 2016 Morningstar publication Assessing the True Cost of Strategic-Beta ETFs found that:

  • Strategic-beta ETFs are considerably cheaper to own than traditional actively managed funds.
  • We expect fees will continue their downward trend as the market matures and competition intensifies.
  • The range of fees across strategic-beta ETFs is wider than it is amongst ETFs tracking traditional market-cap-weighted indices.

When managers are removed from the equation (or at least reduced in numbers) the fund passes the saving onto the investors. The benefit of low fees is only part of the picture.

Smart Beta strategies offer excess return over the S&P 500 to a remarkable degree. The below data from Invesco illustrates the premium earned across nearly every factor methodology in Smart Beta investing, since their respective ETF’s were launched.

Since going live, here is what these smart beta indexes have done!

Since going live, here is what these smart beta indexes have done!

In the case of active mutual funds you can expect to pay more for performance that more often lags behind the market while exposing investors to greater risk. The only winners in the active management game are the managers themselves. Furthermore, the few successful funds that have maintained superior performance can attribute their appreciation to a factor, not a manager or professional team.

A 2011 study performed by the American Association of individual Investors reviewed the performance of 1,500 mutual funds with 10-year track records. The researchers then culled this list down to 600 funds whose managers outperformed their benchmarks by at least 1 percent on an annualized basis. Even within this cohort of exceptional managers faltering performance was common. The authors explain, “approximately 85% of the top managers had at least one three-year period in which they underperformed their style benchmark by one percentage point or more. In fact, on average, they underperformed during six separate rolling three-year periods (out of a total of 29). About half of them lagged their benchmarks by three percentage points (on average, three separate times) and one-quarter of them fell five or more percentage points below the benchmark for at least one three-year period.” Smart Beta ETFs remedy this problem through low costs, rules-based systems and consistency that ignores the problems of behavioral finance.

Corey Philip

Corey Philip is the founder of RealSmartBeta.com. His focus is on expanding investor knowledge of Smart Beta ETFs and quantitative investing. Learn more about Corey in the 'ABOUT' section of this website.

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