I like smart beta.
There, I said it.
I like the innovation and creativity. I am fascinated by the problems and inefficiencies these products try to solve.
And, I love watching someone try to take something that already exists and make it better, which probably explains my unhealthy obsession with ABC’s “Shark Tank.”
Having said that, I am not convinced that these innovative investment solutions are necessary for most clients. In addition to the high fees and complexities, smart beta derails advisors from focusing on the financial pieces they can actually control.
Below are the three C’s that prevent me from injecting smart-beta ETFs into my practice:
1. Costs. The average smart-beta ETF total expense ratio is 0.55%, almost 40% higher than the global average total expense ratio for an ETF and 76% higher than the average Vanguard ETF, according to ETF.com.
Several studies, including a popular one from Morningstar, conclude that expense ratios are still the most dependable predictor of performance. In other words, lower-cost investments have tended to outperform higher-cost investments.
Given these findings, I find myself in an uphill battle right out of the gate with smart-beta ETFs.
2. Complexity. Smart-beta funds deviate from traditional market capitalization-weighted indexes and create new complexities that might not be apparent at first glance.
For example, the move away from market-cap security weighting to equal weighting or dividend weighting, can potentially incur unnecessary turnover. The additional turnover can increase internal costs without increasing future returns and potentially reduce tax efficiency.
3. Control. The second we stray from investing in a passive, broad-market index, we are essentially trying to outguess the market and control something that most of us know we can’t. With robo-advisors putting pressure on fees and commoditizing investment management, it makes less and less sense to spend time trying to sift through the noise and figure out which smart-beta fund might be a fit for clients. I think the client would benefit more from us focusing on things we can control, such as mitigating taxes, assessing risk tolerance and risk capacity, determining optimal asset location, and more.
At the end of the day, I am captivated by the attempt to create new solutions and enjoy the continuing conversations, but smart beta falls short on winning me over. With high costs, covert complexities and added layers of challenges, the potential risks of smart beta outweigh potential rewards.
As they say on “Shark Tank,” for those reasons, I’m out.
Taylor R. Schulte, CFP, is founder and chief executive of Define Financial (definefinancial.com) of San Diego.
This story is part of a 30-day series on smart ETF strategies.
