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How 'Smart' Is Smart Beta?

"Smart is kind of a loaded term."

That line kicked off a discussion of alternative methods of weighting index funds, commonly called "smart beta," hosted by Charles Schwab and held in New York Wednesday afternoon.

In a panel moderated by Ben Johnson, Morningstar's director of passive funds research, a group of leaders from the ETF and index businesses explored issues surrounding the funds that Morningstar prefers to classify as "strategic beta," since all the techniques employ strategies codified in index rules. (Despite Johnson's attempt to change the wording, most panelists used "smart beta" throughout the session.)


According to Johnson, 374 exchange-traded products used these techniques as of June 30, 2014, with portfolios accounting for $360 billion in assets.

Yet Schwab research indicates that 67% of consumers admit that they don't know anything about smart beta.

"We need more clarity, more education," said Rolf Agather, who heads up research at Russell Investments. Russell's own survey of institutional investors shows that about one-third of that group already use smart beta strategies.


While individual strategies vary, the common thread connecting smart beta portfolios is that they avoid the capitalization weighting common in traditional indexes.

Smart beta portfolios "are breaking the link between price and portfolio weight," said John West, head of client strategies at fundamental index shop Research Affiliates.

Luciano Siracusano, chief investment strategist at WisdomTree, described it as "weight by what you want."

In theory, the different weighting methods should lead to excess returns -- but advisors should note that long-term real-world results (as opposed to backtested outcomes) are still years off.

For now, advisors using the funds must choose which weighting they want for clients.

Many of WisdomTree's ETFs are weighted by the absolute dollar value of a stock's dividend payments. So in the company's indexes, AT&T's $9.5 billion in total annual dividends gives it a greater weight than General Electric at $8.8 billion. "Because we weight once a year by dividends," Siracusano said, "we capture dividend growth."

Bill Belden, managing director of product development at Guggenheim Investments, observed that his firm's S&P 500 Equal Weight ETF provides "better diversification" than the traditional cap-weighted benchmark.

Advisors should also be aware that many smart beta strategies overlap. Dan Draper, global head of ETFs at PowerShares, noted that his firm's site has tools to measure correlation and compare exposure of its ETFs. Similar help will soon be available on WisdomTree's site as well.

Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poor’s weekly investment advisory newsletter, The Outlook. 

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