Dumb Beta Strikes Back for U.S. Stocks Starved of Breadth

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In the war between conventional share indexes and the smart beta style that became popular in the last decade, score one for the old school.

With gains in equities confined to the biggest stocks in 2015, equity gauges that emphasize their largest members such as the Standard & Poor’s 500 Index are suddenly trouncing newer rivals that don’t make the distinction. One example is consumer shares, where size-ranked indexes are returning more than twice as much as those that strip out the market-value bias.

It’s a rare soft patch for exchange-traded funds employing smart beta tactics such as equal weighting, which have seen assets surge 10-fold since 2004 to $406 billion, or about 20 percent of the U.S. ETF industry. Buyers have been attracted to the passive investments that fine-tune indexes by ranking companies by factors other than how big they are.

“People are realizing the smart-beta strategy isn’t a magic wand,” said Rick Ferri, the founder of Portfolio Solutions LLC, a Troy, Michigan–based financial adviser with $1.4 billion in client assets. “We have a large-cap growth market right now, and anything weighted towards smaller stocks is getting beaten up.”

Smart Beta

Stretches like this have been unusual in a six-year bull market where virtually everything has risen, a perfect setup for equal-weighted gauges. While the recent performance is ammunition for smart beta’s critics, it’s hardly a repudiation of the style, according to Eric Balchunas, an analyst with Bloomberg Intelligence.

“Smart beta is here to stay,” Balchunas said. “It’s really an artificial intelligence version of active management, and it costs about half the price.”

Megacap companies like Google Inc., Facebook Inc. and Amazon.com Inc. are up 20 percent or more in 2015, meaning you’ve been better off owning old-style indexes where their influence is greatest. The S&P 500 is size-weighted, so stocks such as Apple Inc. and Exxon Mobil Corp. can be hundreds of times more influential than the smallest companies.

On July 20, the S&P 500 traded at its highest level since June 2013 relative to its equal-weighted counterpart, according to data compiled by Bloomberg. The Value Line Arithmetic index, a gauge containing 1,700 stocks with equal weights, is down 5.6 percent since reaching an all-time high on April 15.

Amazon Influence

Amazon.com, whose market capitalization of more than $250 billion makes it the biggest in the 85-stock consumer discretionary group, has accounted for more than one-third of the move in that sector this year -- as long as your index is market-weighted, Bloomberg data show. The stock is up 72 percent in 2015.

The S&P 500 consumer discretionary index is up 11 percent this year, compared with 3.6 percent for an equal-weighted version. The consumer gauge added 0.3 percent at 4 p.m. in New York, while the equal-weighted index slid 0.8 percent.

The same is true in technology. The S&P 500 Information Technology Index is up 2.4 percent in 2015 compared with 0.2 percent for its equal-weighted rival.

The most recent quarterly reports for Apple, Google and Facebook saw double-digit profit expansion. Meanwhile, the full S&P 500 is forecast to see earnings fall 2.8 percent this quarter.

The divergence is prompting investors to be more selective when picking stocks, according to John Carey of Pioneer Investment Management Inc.

Earnings Growth

“The spotlight has been on those very large companies that seem to have an edge in terms of future earnings growth,” Carey, a Boston-based fund manager at Pioneer, which oversees about $230 billion, said by phone.

There’s nothing inherently wrong with smart beta, which also goes by the name fundamental indexing, according to Ferri of Portfolio Solutions. It’s just not a quick fix, with higher fees that make it expensive to shuttle in and out.

“These smart-beta strategies, if you’re going to use them, are a lifelong commitment,” Ferri said. “You’re going to have periods of underperformance like this. If you’re not going to stick it out, don’t do it in the first place.”