Can 'Smart Beta' Funds Really Beat the Market?

Since the first index mutual fund launched back in 1975, the traditional, long-term approach to indexing has been a massive success. For anyone just getting into , it's a proven model. These funds, which simply aim to track a broad market index like the S&P 500, have consistently delivered returns that leave most actively managed funds in the dust. This is one of the most important lessons in .

Given that track record, it’s no surprise that traditional index funds (TIFs) have become incredibly popular. Assets in stock index funds exploded from just $16 million in 1976 to a staggering $2 trillion by early 2017. Bond index funds saw similar growth. This success, however, inevitably attracted competition.

The biggest index fund managers are now locked in fierce price wars, slashing their fees to attract savvy investors who understand that every dollar saved on costs is a dollar earned. While this is great news for us, it cuts into the profits of fund managers and discourages entrepreneurs from entering the space.

So, how have promoters found a new way to capitalize on the indexing trend? By creating new, more complex indexes and packaging them as exchange-traded funds, or ETFs. They sell these products with the strong implication that their novel strategies can consistently outperform the classic market indexes. Of course, they charge a higher fee for this promised (but rarely delivered) outperformance.

A Shift in Responsibility

To understand what’s happening, it helps to see the difference between old-school active managers and these new ETF strategists. A traditional active manager knows the only way to beat the market is to build a portfolio that looks different from the market. They try their best, but collectively, they can't all win—their trading mostly just shuffles ownership around while enriching financial intermediaries.

Sponsors of these new-wave ETFs, on the other hand, don't claim to have a crystal ball. Instead, they typically do one of two things:

1. Offer broad market index funds designed for real-time trading—a questionable claim at best.
2. Create indexes for narrow market sectors, encouraging investors to swap between them in hopes of earning extra profits, though evidence often suggests the opposite result.

What this really does is shift the burden of investment strategy from the fund manager to you, the individual investor. I’m deeply skeptical that this change serves the average person well, especially those looking into for long-term goals.

The Rise of "Smart Beta"

This new breed of indexers has largely chosen the ETF structure to market their products, which they often call "smart beta." In reality, these aren't passive indexes in the traditional sense; they're active strategies masquerading as indexes.

Instead of weighting stocks by their market capitalization (the size of the company), they focus on so-called "factors"—like value, momentum, or size. For example, a smart beta ETF might weight its holdings based on the total dividends each company pays out. It’s not a terrible idea, but it’s not a revolutionary one, either. These strategies rely on computers to sift through historical data to find factors that have performed well in the past. It looks easy on paper, but it isn’t. to build wealth requires a solid plan, not just a trendy one.

The market has a powerful tendency called "reversion to the mean," meaning today's winning factors are very likely to be tomorrow's losing ones. Investors who ignore this are making a huge mistake. We’ve seen this movie before with the "Go-Go" funds of the late 60s and the "Nifty Fifty" craze of the early 70s. Time and again, products built on short-term marketing trends prove to be awful for long-term investors.

Looking at the Record

Despite the risks, assets in these smart beta ETFs have ballooned from $100 billion in 2006 to over $750 billion today. Proponents have called their strategies a "revolution" and a "new paradigm," even comparing themselves to Copernicus for shifting the center of the investing universe. Yet even one of the earliest advocates, the "godfather of smart beta," has described a crash in these strategies as "reasonably likely."

So, what does the data say? Over the ten-year period ending in 2016, two of the original smart beta funds were compared to the S&P 500 Index Fund:

• A earned a 7.6% annual return but with higher risk (17.7 standard deviation).
• A earned a 6.6% return with lower risk (15.1 standard deviation).
• The plain returned 6.9% with a risk level of 15.3.

When adjusted for risk, the simple S&P 500 Index fund was the winner. Furthermore, both smart beta funds had a 0.97 correlation with the S&P 500, making them little more than high-priced "closet index funds."

Stick to the Good Plan

This brings you to a fundamental choice. Do you prefer a certain outcome—capturing nearly the entire return of the stock market—or an uncertain one? Is it better to be safe than sorry, especially when you're trying to figure out reliably over decades?

Many of these smart beta managers are just active managers in disguise, claiming a foresight that history has repeatedly shown to be an illusion. As the nineteenth-century military theorist Carl von Clausewitz famously warned, "The greatest enemy of a good plan is the dream of a perfect plan."

The traditional, low-cost index fund is the good plan. It guarantees you'll get your fair share of market returns and virtually assures you'll outperform the vast majority of other investors over the long haul. While the dream of a perfect, market-beating plan is tempting, it’s better to put dreaming aside, use your common sense, and stick with what works.

Many experts agree. Nobel laureate William Sharpe put it bluntly: "Smart beta is stupid... Betting against the market (and spending a considerable amount of money to do so) is indeed likely to be a hazardous undertaking."