Get Smart About Smart Beta Investing by Scott Mullen, Miracle Mile Advisors

The latest buzz on Wall Street is the so-called “smart beta” ETF. But don’t be fooled by the pretentious name, buying into this seemingly promising strategy is rather complex.

So what is smart beta; what are its risks; and why should it matter to investors?

The term “smart beta” is difficult to define because there is no formal definition. The simplest way to explain smart beta is any weighting methodology that is alternative to traditional market capitalization. This could include something simple, such as equal weighting, to strategies that place an emphasis on specific market factors, such as dividends, low volatility, revenue or momentum. Conceptually, smart beta is designed to add value to investors and potentially increase their chance to get above market returns, better than the S&P 500 for example, without paying excessive fees or taking on additional risk.

Smart beta is a concept of evolution within the asset management industry, and the idea behind the concept has been around for nearly a decade. Strategies have evolved as money managers have tried to develop systematic approaches to outperforming benchmarks under different market conditions.

In the past, equity investors had two choices: low cost capitalization-weighted funds or ETFs. Investors who believed in their investment manager selection process and that markets were inefficient, choose active investment management.  Both approaches have drawbacks.  Cap-weighted equity indexes increase exposure to stocks whose prices are increasing and decrease exposure to falling stocks.  In contrast, active management is not always transparent and comes with higher fees.  As non-price weighted indices, smart beta strategies offer investors a third choice.

The proliferation of the ETF market has resulted in a growing universe of smart beta products. According to a recent study, “The Evolution of Smart Beta,” conducted by Invesco PowerShares and Market Strategies International, smart beta ETFs have further penetrated the market and are poised for additional growth moving forward. Investors now have an even greater number of smart beta products to choose from, all offering a systematic and “different” equity exposure from that offered by traditional equity capitalization-weighted indices.

As companies flood the market with new variations of smart beta products, it becomes important to educate investors on the inherent risks. Investors should not blindly believe that these investments are the remedy for their portfolios. When considering the use of smart beta, or any strategy, investors should have a clear understanding of the expected returns, volatility and other risks associated with that strategy.

Investors need to be aware of several points:

Realistic Expectations

The name can be a misnomer. Investors should not assume that smart beta strategies will never go through poor return periods. If an investor expects these strategies to outperform all of the time they will be severely disappointed. Additionally, it is important for investors to predetermine their objectives from an investment in equity smart beta strategies. Different measurement approaches may vary in whether they determine such an investment a success or a failure.

Tracking

Products tracking these smart beta indices may be “complex or unfamiliar” for individual investors, according to the Financial Industry Regulatory Authority (FIRNA). In addition, exchange-traded products tracking the indices “may be thinly traded and have wide bid-ask spreads,” making these funds more costly to trade.  Excessive turnover and implementation costs will also impact returns

Liquidity Risks

Illiquidity risks can often be a companion to smart beta. Smart beta strategies tend to display increased exposure to value and small-cap stocks relative to capitalization-weighted indices, which could potentially increase the liquidity risk due to the need to regularly trade generally less liquid stocks.

Overcrowding

As more people try to take advantage of smart beta strategies, there is an increased overcrowding risk, which could lead to factor crashes as capacity is used up. Additionally, with so many new smart beta products being introduced to the market, there is always the risk that quality may suffer. In the annual priorities letter, FIRNA included smart beta on a list of eight product categories that it plans to scrutinize for sales violations this year.

Like with any new invention, there will be unintended risks. As an investor, it is important to understand the potential risks that come with your investment choices. Plenty of investors who know about smart beta are not yet ready to begin using such strategies in their portfolios – mostly because they do not know which type of smart beta may be most appropriate. It is vital that investors understand the trade-offs their smart beta strategies may have under a variety of different market conditions.

If you are interested in pursuing a variety of smart beta strategies, be sure to thoroughly educate yourself and work with a firm that is knowledgeable in this space.

Miracle Mile Advisors is a leader in providing independent investment advice through active indexing to high net worth families and businesses nationwide. As one of the fastest growing independent registered investment advisors in Los Angeles, the firm is committed to developing tax-efficient portfolios that benefit from the lower cost and liquidity characteristics of Exchange Traded Funds (ETFs). To learn more about Miracle Mile Advisors, please visit www.miraclemileadvisors.com.

About Scott Mullen

Scott is a Senior Advisor at Miracle Mile Advisors, offering sophisticated financial plans using portfolios with low cost index funds and ETFs. He has nearly three decades of experience within the investment and wealth management industry and serves on the firm’s Investment Committee. His career has been spent primarily working with ultra high-net worth entrepreneurs, families, and private foundations on complex issues of investment management and multi-generational planning.

Scott is an alumni of Harvard Business School, graduating from HBS’ three year Owner/President Management (OPM) program and completed his Bachelor’s Degree from The University of Virginia. In addition, he holds his Financial Industry Regulatory Authority (FINRA) series 65 license. Scott is an active member of the Young Presidents’ Organization (YPO/WPO) and previously served on the board of the MFI Foundation and Advisory Councils for the University of Virginia’s National Committee on University Resources and Fidelity Investments Family Office Service Group.

Get Smart About Smart Beta Investing