What is a Smart Beta Fund? And are they Really Smart?

Recently I posted the blog What is an Exchange Traded Fund? Of course an Exchange Traded Fund is a an investment fund that trades on a stock exchange. For what is index investing you can have a read of the aptly named What is Index Investing? Yes, I know I am not being very creative with my headlines these days, especially for a guy who is a still-recovering former advertising writer and creative director. But simplicity and clarity will have to rule the day, for now.

A traditional index fund will typically buy or own a group of market leading companies. That is, the most valuable companies in each major sector of the economy. We all know that Apple is one of the leading technology companies in the world. So it’s not surprising that Apple makes it into the market indices for large US companies. The most common index for the US market is the S&P 500 and Apple makes up the greatest percentage or weighting of the most famous investment index on the planet. We could say that Apple earned its way into the index by being successful, by making mountains of cash and profits. There is no active manager (decision maker) for the S&P 500 picking Apple as an investment. Valued at almost a trillion dollars, Apple gets in, and makes its way to the top.

Many will call this type of index investing ‘plain vanilla’. I will often use the phrase ‘meat and potatoes’ investing. It’s not too fancy, but it’s darn effective. It allows us to keep our fees incredibly low, to keep more of our hard-earned monies in our portfolio pockets. And the style of core large company (large cap) investing is known to perform better than investments with a lot of guesswork. It’s passive. And this passive style of investing largely and almost exclusively beats the higher fee active investment approach that involves a lot of evaluation and educated guess work. Buying a big bunch of market leading companies is real smart, and very effective. The market leading companies typically earn incredible profits and enough of those companies will typically continue to earn incredible profits for many years or decades.

But there is a style of index investing that was offered the most fortunate title of Smart Beta. Who doesn’t want smart investments? Who doesn’t want to have the word smart in their name or nickname? A smart beta fund will search for ‘certain kinds’ of companies, looking to generate certain kinds of investment performance or investment characteristics.

Minimum Volatility BlackRock

Here’s a simple example: a smart beta fund might only invest in large US companies that have increased their dividend every year, for 25 years running. That fund does exist, and it is called the Dividend Aristocrats Index that can be owned by using the fund ticker NOBL. That smart beta index has an incredible history of actually beating the S&P 500 by well over 1% per year and delivering that outperformance with lesser risk or volatility. Of course as we say in the investment biz, past performance does not guarantee future returns.

Here’s how BlackRock describes smart beta. BlackRock is the market leader for index fund investing with their iShares Exchange Traded Fund (ETF) offerings.

“Smart beta strategies typically capture factor exposures using systematic, rules-based approaches.”

To simplify some of that jargon, the key is that it’s rules based. There can be some simple rules, or a more complicated set of rules that determine how a company might make it into a smart beta index. For example, an index might require that the company pays a very large dividend, has increased its dividend over a number of years, and that the company passes financial health screens. Well as you can guess, that smart beta index does exist and was created by MSCI (Morgan Stanley). That smart beta approach also has a history of ‘beating the markets’ with lower volatility. You can access that approach by way of the Tangerine Portfolios. As you may know that was my old stompin’ grounds and as an advisor I would use that big ‘Juicy Dividend’ phrase to help clients understand the approach.

Big dividends. Growing dividends. Financial health screens.

Tangerine puts together Canadian, US and International dividend payers in their Dividend Portfolio. You can purchase that fund with no trading costs (it’s a mutual fund), and it carries their standard and very reasonable 1.07% annual management expense.

And while Tangerine was the first to make that high dividend smart beta approach investable in Canada, iShares followed up to offer those smart beta funds in ETF form. You can replicate that Tangerine Portfolio and pay fees of .11% for the Canadian dividend fund, .16% for the US fund, and .22% for the International fund. Of course you would have trading expenses as well for each purchase or sell, typically in the range of $5-10 per trade depending on the discount brokerage that you use.

Of course there are many other factors that smart beta indices will apply. Some smart beta indices will screen for smaller companies that are typically known (as a group) to outperform larger companies. Smart beta index funds can weight the companies equally (equal weight) compared to the standard index funds that give more weight or stature to the most valuable companies in the stock market. That equal weighting factor historically outperforms those cap weighted funds as more weight is given to those smaller companies. A smart beta index or fund might also seek out companies that are typically less risky or less volatile. That can be very useful as many or most investors do not enjoy the roller coast ride of the stock markets. Other smart beta funds can seek out ‘Quality’, ‘Momentum’ and ‘Value’.

The most common smart beta factors –

Value Factors BlackRock

Should you use smart beta funds? Here are a few words of caution offered by James Gauthier the Chief Investment Officer at Justwealth, one of the leading Canadian Robo Advisors.

Smart beta funds can be more expensive than core index funds, and they’re usually more complicated. More complexity may not lead to better returns. There is a lot of data out there on securities and computational power is easy and cheap. It’s easy to find a computer and data that will crank out numbers of past performance that does show certain desired results. There’s no such thing as a bad-looking back test, because if it had a bad-looking back test, the index creator would throw it out and start over. 

In my opinion, we might beware the added costs, and ensure that there is a meaningful history of performance through at least the two most recent market cycles. Once again we might keep it ‘simple’ with the use of the most commonly used or embraced factors such as size, dividends (profitability) and low volatility. Many would suggest that we can use the smart beta funds to augment a core portfolio, to tilt the portfolio toward one of the factors. You’ll find the size premium and lower volatility factors at work in some of the Justwealth portfolio offerings as well as with the low fee active manager Mawer Investments that includes a small cap segment in their Balanced Portfolio offerings. The core philosophy at Mawer is value investing.

On Cut The Crap Investing’s ETF Model Portfolio page, I offer a few suggestions in the land of smart beta portfolios that embrace the size premium and dividends. All told you do not have to embrace smart beta. Most investors can get everything they need from core large cap market indices, using the ownership of market leading companies in Canada, US and International with the risks managed by way of core bond funds. Intelligent investing mostly comes by way of sensible asset allocation and low fees.

Happy investing, by way of smart beta or plain vanilla.

Feel free to drop me a note at cutthecrapinvesting@gmail.com, I’ll do my best to give you a smart answer.


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