Trading Lesson: What You Should Know about Smart Beta Index ETFs

08/25/2017 2:51 am EST

Focus: FUNDS

Steven Pomeranz

Host, The Steve Pomeranz Show

Smart beta ETFs have lower fees and higher volume capacity than traditional active strategies. They offer the best of both worlds, writes Steve Pomeranz, CFP. Look for guides on how to get started trading or investing every Friday on MoneyShow.com.


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Today, I plan to talk about smart beta ETFs, the next wave of financial innovation that’s changing the way index funds (ETFs) are structured. But before I do that, let’s go back in time to how index investing got started.

In 1960, two students at the University of Chicago came up with the idea of an “unmanaged investment company” and laid out their model for an index fund.  While their idea did not gain much traction back then, it set the stage for a major innovation in asset management—the world of index funds. A decade later, in 1973, Burton Malkiel, an economist at Princeton University who wrote the best-selling classic A Random Walk Down Wall Street, told the public what Wall Street already knew: that most mutual funds do not beat market indexes.

Specifically, Malkiel wrote: “What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners.”

A few years later, in December 1975, the young founder of the Vanguard Group, John Bogle, started the first index investment trust which tracked the S&P 500 Index (SPX), earning contemptuous jeers from Bogle’s peers who called the fund “Bogle’s folly.”  Even Fidelity Investments’ then-Chairman, the renowned Edward Johnson, said: “He couldn’t believe that the great mass of investors is going to be satisfied with receiving just average returns.”

But, as they say, the rest is history.  According to Vanguard’s website, Bogle’s index fund, which started out with $11 million in assets, has grown to about $560 billion in assets as of June 2017 and has delivered an average annual return of 11% since its inception, with an expense ratio of 0.14%, which is 86% lower than funds with similar holdings…pretty amazing!

Buffett’s ringing endorsement of index funds

The logic of this investing has not been lost on one of the greatest investors of our day, Warren Buffett. Even Buffet showed that he was a strong believer in the fundamental soundness of index funds when he stated the following:

“My advice to my trustee couldn’t be more simple,” he wrote,  “put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”

What’s fascinating about this is that Buffett does not want his surviving family to bother with Wall Street and their active money managers. Although quite a bit will still be invested in Berkshire Hathaway (BRK-A), the excess monies will be directed the way I just described.

Active vs. passive investing

Finally, before I move on to talking about Smart Beta ETFs, let’s quickly revisit the concept of active versus passive investing. 

In active investing, fund managers rely on their own research and insights and attempt to outperform the market by actively trading positions based on various factors impacting a stock’s valuation and future prospects.  In its quest for higher returns, active investing’s approach results in higher expenses, fees, and commissions, so investors pay more for the fund.

Passive investing takes a strictly buy-and-hold view and replicates the holdings of an index, so there is no active research and only a small amount of trading tied to periodically rebalancing the fund to mimic changes in the holdings or weightings of the underlying index. So passive investing has significantly lower expenses and fees.

Index investing has its drawbacks

While many index ETFs can be used as a way to grow your retirement savings over the long-term, they appear to have become victims of their own success.  Here’s why:
CNBC reported, as of July 2017, there were about $4 trillion invested in ETFs, with a record $250 billion in inflows into ETFs in the first half of 2017 alone.  But this huge influx into ETFs can cause problems, as a recent Bank of America report warned.

The report, titled “The ETF-isation of the S&P 500” says that ETFs now own about 37% of the S&P 500 component companies and warns that this could cause severe price distortions, liquidity concerns, and high volatility, especially if one or more of the index’s component companies or sectors get in trouble.

So, the Bank of America report suggests that investors avoid the stocks that make up the components of these indexes for now because they sport a much higher valuation and never-before-seen high premiums to intrinsic value. Instead, the report suggests picking up stocks that are not in the major indexes if you want higher long-term returns.

In essence, $4 trillion is invested in securities that make up ETFs with funds holding large numbers of these shares for the long run—shares they have no interest in selling on a day-to-day basis.  As a result, the true availability of stock to buy and sell oras it’s called, the “true float” of these shares, may have been significantly reduced by more than a third.

In addition, ETFs have been buying stocks that are in the index, without really analyzing them or considering whether they are fairly priced, and this may have caused a price bubble in those stocks, potentially setting the stage for a crash in index ETFs as valuations get distorted relative to fundamentals.

Even Vanguard’s outspoken founder John Bogle and the Henry Ford of index funds believes that there is a point where too much invested in the S&P 500 could be bad for the stock market because of the lack of liquidity and over-priced shares.

But naysayers point to Japan, where passive funds own roughly 70% of the equity markets without any real trouble so far and believe that at 37%, the U.S. is still far from any tipping point.

Smart beta ETFs: the next frontier

So, where do we go from here?  Well, over the past few years, some fund managers realized the potential drawbacks of the typical structure of passive index ETFs. They started setting up smart beta ETFs that don’t just blindly follow the typical index weighting but consider other factors that influence a share’s valuation such as its dividends, book value, or volatility. In general, smart beta ETFs attempt to beat the index, enhance returns, reduce risk, and add diversification in a transparent and cost-effective manner.

In effect, smart beta ETFs are a bit akin to active investing because they try to enhance returns, but their implementation is transparent, systematic, and rules-based and requires little or no discretionary input from portfolio managers. Therefore, they have lower fees and higher volume capacity than traditional active strategies. In essence, they offer the best of both worlds—the market-beating upside potential of active investing and the transparent low-cost advantages of passive investing.

And they seem to be catching on

The Financial Times reported, as of September 2016, smart beta ETF funds had $347 billion globally, and projections see these ETF assets reaching $1 trillion by 2020 and $2.4 trillion by 2025.

Smart beta ETFs are essentially a free-market response to the dominance of traditional ETFs. By joining technology with actively managed strategies, these alternatives are, in effect, actively managed. Looking beneath the surface, this “active” management is not based on human talent but on formulae and algorithms which fit the ETF structure while simultaneously allowing for the potential enhancement of certain sectors or the inclusion of philosophies such as value or growth investing.

So, indexing is great, but, as with most things in life, too much of a good thing can turn sour, and free markets kick-in to provide innovative new solutions. 

For now, momentum appears to favor this “smart” approach but we do not, as yet, have a long enough history of returns to make meaningful comparisons against traditional ETFs. So will this new fund evolution be enough to counter the massive demand for S&P 500 funds? Only time will tell.

To find out more, go to www.stevepomeranz.com

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