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Smart beta: Beating the market with an index fund

Henrik Johnson | E+ | Getty Images

One problem with actively managed stock mutual funds is that even when they beat the market, you never quite know why—or if it's likely to happen again. Now some in the fund world believe they have a solution: smart beta investing.

Don't be put off by the name. Wall Street has never been especially good with product branding. Smart beta has the confounding ring of, oh, structured notes or collateralized debt obligations. But in simplest form, smart beta is a nifty index strategy that will make sense for a lot of individuals.

The central idea is to get away from portfolios weighted by market capitalization and which thus have the greatest exposure to the biggest companies. That's generally how popular low-cost index funds operate: Their holdings are a near-perfect match with cap-weighted benchmarks like the S&P 500. So anyone who owns an S&P 500 index fund automatically allocates more money to shares of, say, Exxon Mobil than to Ball Corp.

But what if the Ball Corps. of the world rise faster, as they often do? Smart beta is all about grabbing that outperformance. "We look at conventional indexes and say there is a better way," said Bob Breshock, managing director at Parametric Portfolio Associates, which runs $19 billion of smart beta assets.

Smart beta strategies vary, but they have one thing in common: Size doesn't matter. Some smart beta funds weight the portfolio according to fundamentals like earnings, dividends and cash flow; others weight it to low volatility or upward price momentum. The simplest and oldest smart beta strategy is equal-dollar weighting: investing the same amount of money in every company in an index, large or small.

For a weekend investor it gets tricky. So think of smart beta funds as actively managed portfolios with costs and risks similar to index funds—and with a clear and repeatable strategy that all but eliminates luck as a factor. Sounds pretty great, right?

(Read more: Training your brain to be a better investor)

How smart is smart beta?

Studies show that it works really well—or at least so far. All the approaches appear to beat the market in the long haul. Consider Guggenheim S&P 500 Equal Weight, one of the first smart beta Exchange Traded Funds. Since inception in April 2003, it has returned an annual average 11.3 percent versus 8.4 percent for a cap-weighted S&P 500 ETF, according to Morningstar.

Rob Arnott, CEO of Research Affiliates, a pioneer in smart beta investing, said these strategies outperform their benchmarks by an average of about 2 percentage points a year in developed markets and by more than that in less efficient markets, such as the stocks of small companies and in emerging markets.

"Smart beta is a rules-based, systematic, transparent, low-cost way of accessing the market," Arnott said in an email. "Smart beta avoids the pitfalls of market-cap weighting, which tends to overweight overvalued securities and underweight undervalued ones."

The equal-dollar approach works, because over time small stocks, which you get more of with this strategy, tend to outperform big stocks. The same can be said of stocks with low volatility and strong fundamentals, such as earnings and dividend growth. "These funds are designed to mimic the positive aspects of active management—isolating and exploiting specific sound economic phenomena," said Ben Johnson, director of passive fund research at Morningstar.

(Read more: Why the government shouldn't push index funds)

So it's not magic. It's also not perfect. The back-tested performance figures of some smart beta strategies smack of data mining, Johnson said. So before investing, make sure you understand the strategy and that it makes economic sense. Another pitfall is that, well, these are index funds, and they cannot react defensively to a sudden downdraft in the market—as an active manager might.

In time, smart beta funds will proliferate, given the current buzz and their recent heady performance. Then their edge will almost certainly melt away. But that day seems far in the future. In an August report, Towers Watson said smart beta investing is "still at the pioneer stage" and "increasing allocations into smart beta strategies may remain powerful tailwinds in the foreseeable future."

An emerging market

The pool of money employing smart beta strategies remains small, and most of it is on the institutional side. Morningstar identifies 163 ETFs with a smart beta strategy. A handful of open-end mutual funds do it, too. The ETFs have $107 billion in assets—just 7 percent of the ETF universe and a pimple on the face of a $13 trillion fund industry.

Yet smart beta ETF assets grew 43 percent the first nine months of 2013 versus just 16 percent growth in total ETF assets. So they are hot. Schwab just launched six smart beta ETFs and has been touring the country explaining how they work.

"Financial advisors are extraordinarily enthusiastic about them," said Anthony Davidow, alternative beta and asset allocation strategist at the Schwab Center for Financial Research.

Nicholas Vardy, a fee-only registered investment advisor at Global Guru Capital, has hopped on board. His clients are in about a half-dozen smart beta funds, including Guggenheim, PowerShares FTSE RAFI US 1000 and First Trust Capital Strength.

"It's kind of a free lunch," Vardy said. "Will it last forever? Probably not, but for now it's a powerful idea." And you'll always know why you beat the market.

By Daniel Kadlec, Special to CNBC.com

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