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 But pursuing a smart-beta strategy isn't as simple as just buying a
fund with that name and thinking it will outperform conventional
index funds. There's always a trade-off in costs, risk and return,
so you need to dig much deeper to get beyond simplistic marketing
pitches.
For example, let's say you were seeking an alternative strategy and
were sour on the 150 or so S&P 500 index funds on the market that
weight their stock holdings by the popularity or market valuation of
the stocks within the index.
Under the dominant "cap-weighting" design, top holdings of a typical
S&P 500 index exchange-traded fund would have Apple Inc at about 3
percent of the portfolio, followed by Exxon Mobil Corp at 2.6
percent and Microsoft Corp. at just under 2 percent. Every other
stock in the portfolio would represent a slightly lower percentage
of the total holdings.
The idea behind cap-weighting is that the most-popular U.S. stocks
represent the largest portions of the portfolio. This is what
economist John Maynard Keynes called a "beauty contest," with
investors bidding up the prices of the most glamorous stocks. The
downside is that these companies may be overpriced and may not have
as much room to grow as other, bargain-priced stocks.
One alternative in the smart beta fund category is an equal-weighted
stock index fund such as the Guggenheim S&P 500 Equal-weighted ETF,
which holds the same stocks as the S&P Index, only in equal
proportions. This design somewhat side-steps the overpricing issue
because it's less exposed to beauty contestants, especially when
they falter a bit.
To date, both the long- and short-term performance of the
equal-weighted strategy has been better than the cap-weighted index
funds. The Guggenheim fund has beaten the S&P 500 index over the
past three, five and 10 years. With an annualized return of 9.7
percent over the past decade through June 6, it's topped the S&P
index by more than two percentage points over that period. But it
costs 0.40 percent for annual expenses, compared with 0.09 percent
for the SPDR S&P 500 Index ETF.
Once you start to ignore the beauty pageant for stocks, is there an
even smarter beta strategy? What if you picked the best stocks based
on a combination of value, sales, cash flow and dividends? You might
find even more bargains in this pool of companies. They'd have
strong fundamentals and might be more consistently profitable over
time.
One leading "fundamentally weighted" portfolio, which also resides
under the smart beta umbrella, is the PowerShares FTSE RAFI US 1000
ETF, which also has outperformed the S&P 500 by about two percentage
points over the past five years with an annualized return of 20
percent through June 6. It costs 0.39 percent annually for
management expenses.
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The PowerShares fund owns some of the most-popular S&P Index stocks
like Exxon Mobil, Chevron Corp and AT&T Inc, only in much different
proportions relative to the cap-weighted indexes. The RAFI approach
focuses more on cash, dividends and finding undervalued companies,
so it's not necessarily looking for the most-popular stocks.
Although looking at the rear-view mirror for index-beating returns
seems to make equal- and fundamental-weighted strategies appear
promising long term, you also have to look at internal expenses to
see which strategy might have the edge.
Turnover, or the percentage of the portfolio that's bought and sold
in a year, is worth gauging in both funds. Generally, the higher the
turnover, the more costly the fund is to run. That eats into your
total return. The PowerShares fund has the advantage here with an
annual turnover of 13 percent, compared to 37 percent for the
Guggenheim fund.
Over the long term, "fundamentally weighted smart beta strategies
are likely to outperform the equal weighted approach," note Engin
Kose and Max Moroz with Research Affiliates, a financial research
company based in Newport Beach, California, which largely developed
the concept of fundamental weighting and is behind RAFI-named
indexes.
But just considering costs doesn't end the debate on equal- and
fundamentally weighted funds. While they may be higher-performing
than most U.S. stock index funds over time, they are not immune from
downturns. Both lost more than the S&P 500 in 2008 and 2011.
While it may be difficult to predict how these funds will perform in
a flat economy or a sell-off, they are worth considering to replace
your core stock holdings, and may be the wisest choices among the
smarter strategies.
(The opinions expressed here are those of the author, a columnist
for Reuters)
(Follow us @ReutersMoney or at http://www.reuters.com/finance/personal-finance;
Editing by Beth Pinsker and Dan Grebler)
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