Five Ways to Be Smart About ‘Smart Beta’ Funds

Here’s what smart-beta, or factor-based, funds are and what to consider about them as they show up more in retirement plans

As individual investors flock to so-called smart-beta funds, the question is whether they are doing so with all of the wisdom the strategy demands, or simply chasing the latest trend the financial industry is promoting.

Smart-beta funds—which are also called strategic-beta funds or factor-based funds by some—track indexes in much the same way passive investments do. The difference is that instead of weighting holdings by market capitalization, the funds select securities with qualities or “factors” that research suggests are associated with outperformance or lower risk, such as

  • earnings growth,
  • value,
  • price momentum or
  • high dividends.

According to data provided by research firm Morningstar Inc., assets under management in exchange-traded funds that it classifies as taking this quantitative-based approach to investing have more than doubled since December 2014, rising to $1.09 trillion as of the end of September.

Invesco Ltd. IVZ -1.13% , one of the providers of factor-based vehicles, calculates that for every $4 investors allocated to ETFs as of the end of the third quarter, $1 went to an ETF employing some kind of smart-beta strategy. Those asset gains came as advisers report seeing more factor-based mutual funds in 401(k) plans and despite underwhelming returns from some asset managers employing smart-beta strategies over the past 18 months.

“Now that these products have accumulated a critical amount of assets and have a track record behind them, that’s helping with their adoption” by both investors and financial advisers, says Jason Stoneberg, senior director of ETF research and product development at Invesco. “Investors are always looking for better, more efficient ways to access the market, so this ability to customize portfolios appeals to them.”

So, what do investors need to know before jumping into the factor-fund pool? Here are five things they should keep in mind:

1. The strategy isn’t all that new

Some may refer to smart beta as a recent innovation, and many investors think that is what they are getting. In reality, quantitative investing, or using data to create a portfolio with a particular kind of tilt in an effort to outperform the market or reduce risk and/or volatility, dates back about half a century.

What is new is that a strategy once employed mainly by institutional investors is now available to the masses, thanks to technology and a wider range of market data that allowed fund firms to create new investing models using quantitative tools and package them in products with low fees.

So while the first ETFs carrying the moniker of smart beta made their debut in 2003, the investing approach employed by these funds has a longer history than many investors realize.

Peter Lazaroff, chief investment officer of Plancorp, a St. Louis advisory firm that manages $4.2 billion for high-net-worth families, says his firm has been using quant products since the mid-1990s. “But what has changed a lot in the last few years is that the number of offerings has multiplied, and in the last two or three years we’ve really seen the costs go down.”

How fast have these funds multiplied? According to Morningstar, there are more than 700 strategic-beta ETFs, up from 364 in 2014.

2. They aren’t as ‘passive’ as you might think

Advocates like to emphasize the characteristics that make factor-based funds close cousins to index funds, but investors shouldn’t be fooled into thinking that is what they are. These products are more complicated.

Sure, fees on factor-based funds generally are lower than on traditional actively managed portfolios, and most factor-based funds track some kind of index. But those indexes are unique, constructed specifically for the fund by people who made a series of decisions, based on their reading of the data, on which securities should and shouldn’t be included. As such, smart-beta funds, like actively managed investments, can look and behave very differently, depending on who created the index’s rules and on the analytical approach or assumptions that individual or group used.

Say an investor wants a smart-beta fund focused on high-value stocks. Well, each fund might have a different perspective on the best way to capture value, and even a different view of what a value stock is. One might pick the 100 stocks in the S&P 500 with the lowest price/earnings ratio and most consistent quality; another might emphasize price-to-book ratio (which compares a firm’s market value to its book value) and low volatility.

“Anytime you have some kind of active decision being made, by a human manager or in executing on a formula,” the investment strategy becomes less precise than what an investor may suppose, says Patrick Huey, principal adviser at Victory Independent Planning, based in Portland, Ore.

As for costs, expense ratios on strategic-beta ETFs average about 0.17%, according to a Morningstar report from last year, which is generally higher than the typical passive investment tied to a cap-weighted index like the S&P 500 but significantly lower than an actively managed mutual fund. Still, the overall cost of a factor-based fund can end up being more than investors realize. That’s because factor-based funds tend to buy and sell securities more frequently than the typical index fund, leading to higher trading costs.

3. Look past a fund’s name to its construction and methodology

A lot of factor-based funds have similar names. But they can be very different for the reasons described above. As such, smart investors will do their homework to understand exactly what they are getting.

Ken Nuttall of New York-based BlackDiamond Wealth Management says even he has been caught off-guard by products that sound similar but in fact offer dissimilar strategies and returns.

“I only just realized there is a difference between a low-volatility fund and a minimal-volatility fund,” he says. The former involves creating a portfolio of those stocks in S&P 500 with the lowest volatility. Minimal volatility, he explains, means creating a portfolio of stocks that, when combined, are characterized by lower volatility, even though some individual holdings in that portfolio might have very volatile stock charts when viewed in isolation.

In today’s competitive marketplace, fund firms should be able to give a quick summary of how their product differs from its peers in terms of construction and methodology. If that isn’t clear in the prospectus, or in other investor communications such as quarterly reports, well, that’s a red flag.

Among other things, the fund firm should make clear how often the fund rebalances its holdings—which can drive up expenses—and whether there is a provision that might allow a manager to override the rules that govern the fund’s operation most of the time—which could turn the fund into something the investor wasn’t expecting.

That said, investors should be wary of any marketing materials that might suggest the funds are more customized than they are. While factor-based strategies allow investors to home in on securities with certain characteristics, the funds aren’t customized portfolios.

“Treat these funds the same way you would an active fund,” cautions Alex Bryan, director of the passive research strategies team at Morningstar. “You really have to look under the hood.”

4. Any factor can stop generating healthy returns for a long time

The argument in favor of factor-based investing is that long-term research shows that over full market cycles adopting certain tilts in a portfolio improves the chance that it will outperform a broad market index.

The reality? Regardless of what historical data say, any single factor can be out of favor for a long time, leading an investor to wonder whether they are doing the right thing. (Just ask die-hard fans of value investing how they feel about the current bull market, driven higher by growth stocks and often by momentum.) And sometimes factors that are supposed to deliver completely different return patterns (say, value and momentum) end up behaving in roughly the same way. Look no further than the 2008 financial crisis, when most asset classes fell in tandem.

Investor psychology is crucial.

Be prepared to stick with your strategy for at least a full market cycle to capture the benefits of what you’re trying to do, and be honest with yourself about your tolerance for tracking error relative to the index,” counsels Mr. Huey.

Advisers often underestimate a client’s willingness to follow an idea that loses money on a relative basis year after year, even if history tells them it will work out eventually, adds Mr. Lazaroff.

5. Yes, these funds can be strategic core holdings—if used appropriately

Now that individual investors can access factor-based investing strategies through tax-efficient ETFs, there is every reason to at least consider using one or two of these funds as a strategic long-term investment, assuming the fund’s strategy makes sense and it provides adequate liquidity (meaning it is easy to buy and sell shares without affecting the asset’s price).

The key for investors is to understand what they are hoping to accomplish by investing in a fund with a particular tilt instead of a more traditional one, and how the product fits in with the other investments in their portfolios.

“Understand that owning a minimal-volatility fund because you’re worried that the market will crash will still leave you with a lot of exposure” to stocks, says Mr. Nuttall.

One Cause of Market Turbulence: Computer-Driven Index Funds

In many ways, this stampede toward passive investing — in which people put their money into funds that track indexes and broader market themes as opposed to relying on human stock pickers — is uncharted territory.

.. the key question is how this transformed market holds up during a financial storm that lasts more than a few days.

.. Cheaply priced exchange-traded and index funds .. They now own close to 40 percent of stocks in the United States

.. BlackRock..  is the leading issuer of exchange-traded funds, with $1.3 trillion under management

.. The popularity of E.T.F.s has concentrated unparalleled financial power in BlackRock and Vanguard, the two biggest providers of index funds and E.T.F.s. Together, they sit on $10.5 trillion in assets and control 65 percent of the 1,700 exchange-traded funds that exist.

.. As the flows have grown in volume, much of these funds have gone toward index heavyweights like Amazon, Apple and Facebook, pushing their valuations ever higher.

.. Active fund managers — human stock pickers  .. because they are the ones who buy when others sell.