Smart Beta ETFs Draw Big Dollars And Critics

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It's a small niche getting big attention.

So-called smart beta exchange traded funds promise investors higher returns or lower risk relative to a standard benchmark such as the S&P 500. To achieve this, fund managers screen stocks based on measures ranging from growth and value to momentum and volatility and eschew the standard index-building tools of market capitalization (S&P 500) or price (the Dow industrials).

It's more than a purely passive investing approach, less than active management. So expense ratios tend to be lower than among actively managed funds.


Although smart beta ETFs have been around for roughly 14 years, demand has surged recently. They are increasingly drawing the mom-and-pop crowd investing in stocks .

Assets in smart beta ETFs totaled $335.5 billion at the end of July, up 26% from July 2013, according to Morningstar Inc.

"This is a category that has been punching above its weight," said Ben Johnson, director of passive funds research, in a May report. He noted that the 342 smart beta funds in the U.S. stock market in 2013 accounted for 18% of total industry assets that year but 35% of net inflow.

Now, on the heels of success, come analyst concerns. Some critics contend that smart beta funds often deliver less than promised, may not efficiently track their indexes and have liquidity issues.

In serial blogs earlier this year, ETF.com analyst Elisabeth Kashner argued that the category could not even be properly or consistently defined.

Kinder, Gentler Strategic

Even Morningstar's May report urged a name change: to strategic beta. Johnson wrote that this alternate terminology emphasized strategic objectives, without implying traditional indexing is dumb.

Still, "smart beta" has marketing zing. Compass EMP Funds used the term in July to announce three new ETFs.

For Stephen Hammers, Compass' chief investment officer, his smart beta methodology gives investors better returns with a little less risk. At the same time, he notes, it offers better diversification than cap-weighted indexing.

Compass' ETFs track proprietary volatility-weighted indexes. So investors in the U.S. 500Volatility Weighted Index ( CFA ) own the 500 largest U.S.-based companies screened for profitability and weighted by the volatility, or risk, of individual securities.

"Our indexes beat 97% of active mutual funds in the last 10 years ending June," Hammers said.

Compass ETFs now have $28.8 million in assets.

Fundamental Factors

Unlike traditional passive indexing, most smart beta ETFs use a fundamentally weighted method. Smart beta leader WisdomTree weights stocks based on their earnings or dividends.

The strategy is paying off for WisdomTree. Net inflow soared from $1.4 billion in 2006 -- the year WisdomTree ETFs debuted -- to $14.3 billion last year.

The company's 69 ETFs had a combined $34.8 billion in assets as of July.WisdomTree SmallCap Earnings ( EES ) rebalances once a year. The weightings of its 800 component stocks are adjusted based on their profits, which helps to lower the fund's price-earnings ratio, says Luciano Siracusano, chief investment strategist at WisdomTree. In the past five years, the fundamentally weighted EES returned an average annual 18.02% vs. the cap-weighted iShares Russell 2000's ( IWM ) 16.22%.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: CFA , EES , IWM

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