My first encounter with a smart beta ETF was a WisdomTree product over ten years ago.

WisdomTree uses index weighting methods other than market capitalization for its ETFs. This one in particular was weighted by earnings or dividends—I can’t remember.

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I thought that presented an interesting philosophical question.

WisdomTree had, in essence, created its own index. An index it believed would outperform another index.

But wait—isn’t the whole point of an index to track the market? Since when are we constructing indices to outperform the market?

This is what is known as “smart beta,” the idea that you can build an index that will provide superior returns at a lower cost—with perhaps reduced volatility.

So how do people come up with these things?

How Smart Beta ETFs Are Built

You backtest.

You start from some economic premise—say, that companies with lower valuations will outperform over time. Next, you build a hypothetical index, and then you go back in time to see if that is true.

If it’s true, you build an index around it.

Mutual fund companies are quick to tell you that past performance is not indicative of future results. Yet, a lot of money plows into smart beta strategies based on past performance!

Unfortunately, you can pretty much backtest anything. In one of the greatest pieces of financial journalism, ever, Dani Burger at Bloomberg created a hypothetical smart-beta ETF that was based on cats.

It outperformed the market by nearly 850,000%.

Ha—I am already long four cats, maybe I should get more!

Some people would call the cat study silly, because there is no economic basis for believing that cat investments will outperform. But that is kind of where we are today in ETF-land.

Researchers spend a lot of time backtesting stuff until they find something that works, then build a marketing plan around it.

Backtesting is not forward-testing. I’m predicting headlines in 2–3 years about smart beta ETFs failing to deliver on their promises.

Don’t Fool Yourself

If there is one thing we should have learned from the passive investing revolution, it is that you cannot systematically outperform the market over time. Even if you figured out how to, other people would discover the anomaly and pile into the strategy, driving down returns.

There might be other reasons to invest in smart beta products—say, you really believe in the economic premise of the ETF—but I believe more in the market’s ability to exhibit non-stationarity, rendering all strategies useless over time.

That’s one of the reasons why trading is an exercise in emotional fitness. You have to be willing to switch things up when they’re not working anymore.

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