Smart Beta: The Investing Buzzword That Won't -- and Needn't -- Die

Photograph: Getty Images Close

Photograph: Getty Images


Photograph: Getty Images

It's hard to find an investing expert who likes the term "smart beta." It makes the Nobel Prize-winning economist William Sharpe "definitionally sick."

Yet those who want to banish the term find it's as fiercely persistent as Monthy Python's Rabbit of Caerbannog, a cute and formidable animal that's nearly impossible to kill.

A marketing term that infiltrated the world of exchange-traded funds (ETFs) a few years ago, smart beta is used to describe ETFs that consider anything other than market capitalization in weighting their holdings. The SPDR S&P 500 ETF Trust (SPY), the world's largest ETF, is weighted by market cap. Like the S&P 500 Index that it's based on, SPY apportions its holdings to each stock based on the size of each company. This is beta. Smart beta says you can outperform a market-cap-weighted index if you select and weight the stocks by metrics such as dividends, volatility, revenue or momentum. Or you can weight each stock equally, which gives more heft to smaller companies.

There's nothing new about investing based on these different factors. The ETF industry just took those approaches and packaged them into passively managed, low-cost funds. Smart beta fills the gap between active and passive management.

Investors seem to like the idea. Smart-beta ETFs' assets are up to $350 billion, a 30 percent increase in the past 12 months, according to Morningstar. But with its success, smart beta has become controversial. Go to any ETF conference and many panel discussions – no matter the initial topic – often end up debates about smart-beta ETFs.

The heart of the controversy comes from the word “smart.” It implies that market-cap-weighted ETFs are dumb. Smart-beta ETFs won’t always outperform the rest. A classic case is a popular smart-beta ETF called the PowerShares Low Volatility ETF (SPLV), which tracks the least volatile stocks in the S&P 500. It has beaten the broader market at times, as in 2011. At other times, such as 2013, it has fallen behind and looks a lot less smart.

It's easy to see why many have tried to kill off "smart beta." They've introduced their own substitute terms, labeling such products strategic beta, advanced beta, alternative-weighted, factor-based, non-market-cap weighted or simply strategy funds.

Many of these terms are no doubt more technically accurate. They just don’t have the zing of smart beta. Smart beta is a little like Obamacare, which is way catchier than the Patient Protection and Affordable Care Act. Obamacare may not be accurate, but everyone calls it that and we all know what they mean.

Ditching "smart beta" would make sense if it were seriously confusing people. But investors recognize "smart" as a marketing term like many others: Growth funds don't always grow, and value stocks aren't always a good value. Investors are finally getting their heads around the concept of smart beta. Substituting a bunch of new terms now would just confuse them.

At this point, the genie is out of the bottle, and we should spend our energy educating investors on what smart beta is all about. Even the President calls it Obamacare now.

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