Why “Smart Beta Indices” can be Smart for your Portfolio

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Most of our clients are very familiar with our core and satellite investment approach where we see the investing world in primarily three investment classes: equities, fixed income, and alternatives. Furthermore, they have heard us preach that we like to use low-cost, generally passive vehicles for the traditional asset classes (equities and fixed income) and active vehicles for the non-traditional alternative asset class. What they may not realize is that we also utilize something that falls somewhere in between truly passive and truly active, something known as “smart beta” or “enhanced” indexing. 

We’ve always been proponents of low cost. Active management brings higher expenses to the table as those management companies need to pay for overhead (such as talent, rent for bigger buildings, marketing, etc) that passive shops do not. This generally leads to higher expenses, higher transaction costs, and more tax ramifications for the investor which explain the empirical studies that show that over time active management funds underperform their benchmark. If one believes in relatively efficient markets, then these active/higher fee funds don’t make much sense when there are passive vehicles that follow an index with much lower fees. In fact, as of August 2012, actively managed mutual funds had a weighted average OER (Operating Expense Ratio) of 0.88% whereas passively managed mutual funds had a weighted average OER of 0.13%.* By going passive instead of active, that difference of 75 basis points goes straight to one’s bottom line, all else being equal.

However, as great as low cost index securities seem, they are not perfect. 

Let me explain: traditional indices are capitalization-weighted. Which mean cap-weighted index funds overweight the biggest companies and underweight the smallest ones. For example, using cap-weighted methodology, an S&P500 Index fund’s biggest holding currently would be Apple at about 3% and its smallest holding would be Graham Holdings at just 0.02%. Apple’s weighting is 150 times Graham’s holdings! Should we be taking a 150x bet on Apple versus Graham? Maybe, maybe not. What we do know is that empirical studies show that there is a small size and value premium. Hence, cap-weighted equity index funds tend to overweight overvalued securities and underweight undervalued ones, creating a 2% return drag in developed markets and more in less efficient ones, according to Rob Arnott at Research Affiliates.

So if smart beta indices aren’t weighted by capitalization, then what are they weighted/created by? One of the first methods to come about, and one of the simplest ones, is equal-weighting. For example, an S&P500 equal-weighted smart beta index would have 0.20% of every one of the 500 companies within the S&P. Another example would be fundamentals-weighting which is where weights of the portfolio are determined by fundamentals like earnings, dividends, and cash flow. (FYI, DWM utilizes this method within its Core Equity model via the Schwab Fundamental US Large Company Index [symbol: SFLNX]). Other smart beta indices weight the index to low volatility or upward price momentum. The one thing they all have in common is that size does not matter. And, because of that, we’ve seen outperformance. 

Smart beta utilizing non-price-weighted indices can be quite attractive. Smart beta indices retain the benefits of traditional cap-weighted indices, such as broad market exposure, diversification, liquidity, transparency, and low cost access to markets, while at the same time they offer the opportunity to achieve enhanced performance over the cap-weighted benchmark. 

Smart beta strategies are pretty exciting yet also can be pretty complicated to many. One really needs to “look under the hood” to get a good understanding of exactly how these work. Be sure to use an investment professional like DWM to filter through all the different choices when investing.

*Mutual fund expense ratios as of August 21, 2012. Asset weighting based on net assets as of July 31, 2012. Data provided by Morningstar, Inc. Passive funds are those coded by Morningstar as Index Funds.