(Bloomberg) -- Index funds became popular over the last four decades because they’re simple, conservative and low cost. A different kind of exchange-traded fund is drawing record cash by promoting better returns with the same stocks.

Known by names such as smart beta and fundamental indexing, they weigh stocks differently -- by focusing on dividends or sales, for instance. Supporters are quick to note that some methods, such as eliminating price rankings, result in returns that beat the Standard & Poor’s 500 Index over the last five years. They’re slower to note that fees can be 10 times higher than a traditional ETF.

“It feels like an inflection point for these strategies,” Daniel Pytlik, who helps oversee $288 billion at Bank Julius Baer & Co. in Zurich, said in a Feb. 20 interview. “There seems to have been an acceleration of both demand for and supply of smart beta. Lots of things are going on in terms of the debate around the topic.”

ETFs guided by the philosophy that you can boost performance by changing the way benchmark measures are put together got $43 billion last year, bringing assets to a record $156 billion as of the end of last month, data compiled by Bloomberg show. Securities from the WisdomTree Japan Hedged Equity Fund to the Guggenheim S&P 500 Equal Weight ETF are raking in cash and charging higher fees, raising concerns about how well investors understand them.

Fooling Buyers

Calling an ETF smart beta is a marketing tactic designed to fool buyers into thinking it is infallible, said Rick Ferri, who helps oversee $1.3 billion for clients as founder of Portfolio Solutions LLC in Troy, Michigan. In reality, they lag behind more traditional gauges for extended periods and add risk.

“It all looks and sounds good on paper, but the guarantee is that it is going to cost you more money, you are going to take more risk, and you can underperform for a long time,” Ferri said in a phone interview on Feb. 19. “If all these people are outperforming the market, who is underperforming? There is no such thing as a free lunch. The product providers are selling the sizzle rather than the steak.”

Smart beta occupies a middle ground between passive funds such as the Vanguard 500 Index Fund, founded in 1976, and the active management popularized by firms such as FMR LLC’s Fidelity Investments. Designers build their own indexes or change existing ones, trying to boost returns by ranking companies not by price, but by measures such as volatility and dividend payments.

Varying Influence

The S&P 500 is size-weighted, meaning that stocks such as Apple Inc. and Exxon Mobil Corp. can be as much as 163 times more influential than the smallest companies. Weighing every company equally, regardless of size, so that each takes up 0.2% of the index will change its return over time.

Stripping out market weights was a tactic tailor-made for American equities in 2013, a year when almost every company rallied. A total of 460 stocks in the S&P 500 advanced, the most since at least 1990, as the U.S. Federal Reserve pledged to keep interest rates near 0%. The biggest 100 companies in the gauge limited its performance, rising 27%. Apple gained 5.4% and Exxon increased 17%.

S&P 500 futures were little changed at 9:40 a.m. in London.

Buying the biggest exchange-traded fund on the S&P 500 the moment equities bottomed in 2009 has returned 175%. Rearranging the ETF to remove size biases has resulted in a gain of 256%, according to data compiled by Bloomberg. The Guggenheim equal-weight ETF, overseen by a unit of Chicago-based Guggenheim Capital LLC, acts that way. It lured almost $2.2 billion last year, the most since its inception in 2003.

Value Tilt

Since the largest companies get no extra space in Guggenheim’s fund, it behaves like a value investor, loading up on lower-priced shares.

While reducing the influence of popular companies generates higher returns over the long run, it’s no guarantee of success every time, said Paul Bouchey, who helps oversee about $120 billion at Parametric Portfolio Associates LLC in Seattle.

“Sometimes value is going to hurt you, sometimes it is going to help you,” Bouchey said by phone on Feb. 21. “But people are starting to realize that fully following market consensus, through every period, is maybe not the best way to get exposure.”

The Dow Jones Industrial Average, the 117-year-old American equities benchmark index, ranks its members by the price of their shares rather than by their overall size.

Japan Fund

Within the newer category of ETFs, the one that got the most money last year was from WisdomTree Investments Inc., the New York-based asset manager whose stock almost tripled in 2013. Clients sent nearly $10 billion to its Japan-hedged equity fund, lured by its ability to eliminate the impact of yen fluctuations on shares trading in Tokyo. The ETF qualifies as smart beta because its members are selected based on their dividends.

Fundamental indexing traces its lineage to Research Affiliates LLC, a firm based in Newport Beach, California and founded in 2002 by Rob Arnott, a former Salomon Brothers Inc. strategist who spent four years editing the Financial Analysts Journal. Arnott, who manages money for Pacific Investment Management Co., preached stripping indexes of market biases and apportioning membership by sales, cash flow, book value and dividends.

Most equity indexes are like the S&P 500, sorted according to market value, which means the bigger a company gets, the more influence it exerts. Arnott’s insight, published in a 2005 paper with Research Affiliates colleagues Jason Hsu and Philip Moore, was that those benchmark measures were prejudiced toward higher- priced shares -- the ones that had already been discovered by investors and had the biggest sway.

‘Adds Value’

“When you dig down, smart beta adds value because they don’t weigh on price,” Arnott, whose firm’s assets under management rose more than 60% to $121 billion last year, said on Feb. 24 by phone. “They don’t reward a company just for having a higher price, and that is where the central source of value added for every segment of smart beta space lies.”

Ignoring capitalization weightings doesn’t guarantee success. Such a strategy in the S&P 500 would have generated inferior returns during the 1990s bubble, when gains were concentrated in a handful of technology giants. An equal-weight strategy would have declined less in the aftermath.

The iShares MSCI USA Minimum Volatility ETF, which invests in stocks that have the narrowest price swings, is up 43 percent since it started in 2011. More than $1.3 billion flowed to the security last year, data compiled by Bloomberg show. It’s designed to beat the market in times of volatility.

Improve Transparency

EDHEC-Risk Institute, a business school with offices from Singapore to London, has said the industry must improve transparency in their index selection. The school promotes about 3,000 smart-beta indexes.

“The products available are not fair to investors, providers don’t fully disclose where the risks are,” Eric Shirbini, global-product specialist for EDHEC’s ERI Scientific Beta team in London, said in an interview. “They are new and growing in significance, and that is why we put so much emphasis. Smart beta is here to stay, so it is very important for people to understand the risks.”

Many smart-beta strategies are based on formulas that are not publicized, Shirbini said. Both Research Affiliates and Think Out of the Box Asset Management, or TOBAM, a fund manager in Paris, show their index constituents.

Management Fee

TOBAM’s Anti-Benchmark Euro Equity Fund charges a 1% management fee, more than 10 times the cost of the SPDR S&P 500 ETF Trust, the world’s biggest fund with $157 billion.

“Most people when they buy an index say they are neutral, and that’s wrong,” said Yves Choueifaty, the founder of TOBAM, who sold the firm to Lehman Brothers Holdings Inc. in 2006 only to buy it back two years later. “You are paying up to be invested in the stocks that have already done very well.” His firm oversees almost $6 billion.

Smart-beta strategies have beaten capitalization-weighted indexes over the past five decades, according to data by Towers Watson & Co., a New York-based consulting firm. Indexes that select stocks with the smallest daily price swings, known as minimum variance, those that maximize diversification, those that focus on fundamentals and those using equal weighting, have gained an extra 2 percentage points a year on average since 1964 relative to market-cap indexes, its data show.

Pension Funds

Today, enthusiasts for the strategies include pensions such as Sweden’s AP2, the California Public Employees’ Retirement System, or Calpers, and Telefonica SA’s Fonditel. BlackRock Inc.’s iShares and Ossiam have constructed funds that invest money based on each stock’s volatility.

AP2, the state pension fund in Sweden that oversees $35 billion, tried smart beta in 2002 through an equal-weighted portfolio of Swedish stocks, followed in 2006 by investments in a RAFI index, said Tomas Franzen, its chief investment strategist. Now, 50% of the fund’s equities are in the strategies as a way to diversify and hedge against market drops, Franzen said.

“It’s not that these alternative indices will outperform in all market situations, but over the long term our experience is that they have outperformed,” Franzen said by phone from Gothenburg, Sweden, on Feb. 13. “Our view is that this will more likely continue to add value to your portfolio and certainly in risk-adjusted terms.”

Public Pensions

Fonditel, the pension-manager unit of Telefonica, Spain’s largest phone company, uses the strategies, said Javier Gonzalez, a press officer in Madrid. Calpers, the largest U.S. public employees’ pension plan, has taken its bet on smart beta a step further by investing in Choueifaty’s TOBAM. Amundi Asset Management, which oversees about $1 trillion, also owns shares in TOBAM.

The PowerShares FTSE RAFI US 1000 Portfolio, introduced in 2005 to invest along criteria designed by Research Affiliates, has gained 243% since the S&P 500 touched a 12-year low in March 2009. That compares with a 175% gain for the SPDR S&P 500 fund. The RAFI index selects stocks based on dividends, cash flow, book value and sales.

The WisdomTree Japan ETF jumped 38% in 2013. That beat the 25% increase for the iShares MSCI Japan ETF tracking MSCI’s market-cap stock index.

Choueifaty at TOBAM is unfazed by criticism, saying the role of benchmark indexes will be questioned as more people use non market-cap weighted gauges.

“When we first started, it really was like preaching in the desert,” Choueifaty said. “The more of us who diversify, the faster traditional benchmarks will end up being diversified.”

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