“Smart” Beta

They’re marketed as “smart” beta funds, but Kyle Tetting warns investors to clearly understand what they’re buying into with popular new index-like investments. Kyle spoke with Joel Dresang in a Money Talk Video.

Joel Dresang: Kyle, we’ve talked in the past about passive, low-cost index funds. We’ve also talked about value-added actively managed funds. There’s this crossover category that’s rising more. It’s commonly called “smart” beta funds, what are those?

Kyle Tetting: “Smart” beta is this idea that over time we’ve seen so many assets flow into just traditional indexes that it has created some opportunities to make some slight tweaks to those indexes – the idea of getting a little bit more for your risk.

So what we’ve seen is a new breed of indexes that’s really created on a slight variation of the rules. And ultimately, what you get is something that behaves a little bit differently, potentially takes advantage of something that isn’t in the index, but does so in an index way.

Joel: What are they trying to do?

Kyle: Really what they’re looking for is mispricings that result from the index.

So you look at something like the S&P 500, a very traditional domestic stock index. It is market cap weighted, so the largest stocks are going to be the largest positions in the index.

But what we have seen with “smart” beta is that they’re emphasizing other things like revenue, earnings, even looking at things like low-volatility or high-volatility stocks as a way to take advantage of something other than just market capitalization.

By focusing on something else, they can try to take advantage of some mispricings. Ultimately, they’re trying to generate some excess return for that level of risk.

Joel: For the investors, what are the advantages to these “smart” beta funds?

Kyle: I think the big advantage is as we saw that rise in indexing, there were a whole host of mispricings in a lot of securities because things just weren’t being recognized. There really are things out there in the market that are worth more than market capitalizations – earnings being a big one, revenue being a big one. And so, taking these “smart” beta approaches – really focusing more on those as the makeup of the index rather than just the market cap – ultimately can take advantage of some of those mispricings.

Joel: And what about the cons?

Kyle: You know, I think the big con for investors is that this is very much a catch-all term. To say I want to be a “smart” beta investor isn’t really saying much. So you really need to understand what you’re investing in.

And I think the other piece is we have seen a lot of funds flow into indexing. We’ve started to see some pretty significant flows into “smart” beta strategies. So a lot of the mispricings that maybe were prevalent because of the rise in indexing are going to inevitably come about in “smart” beta as well.

Joel: So these funds haven’t been around very long. They’ve already grown to like half a trillion dollars in fund values. What do we know about them?

Kyle: You know, looking ahead, we don’t know a whole lot, but that’s true of any investment. I think more importantly, most of these are pretty easy to back-test.

So you look at the rules that make up how the index is constructed, and you can go back in time and say this is what the index would have looked like a year ago, two years ago, three years ago. And you can put together what returns would have been.

Related Money Talk Videos featuring Kyle Tetting include:

Actively managing investment risk
Indexes: Low costs, less flexibility
Beta: Learning how risky an investment might be
That’s part of the problem too, is when you’re back-testing this stuff, a lot of times you’re just shopping for, well, what’s the best possible set of rules that I could use to create this “smart” beta index?

The big problem is you need to know what you’re getting, and so for any investor who’s reading about “smart” beta, who thinks that this may be the next big thing, I urge caution in that there are just so many different strategies that fall under that umbrella that it’s really important to understand what you’re getting.

Kyle Tetting is director of research at Landaas & Company.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Peter May

(initially posted July 28, 2015)