ETF Strategist

Are smart beta ETFs really a free lunch?

Constance Gustke, Special to

Smart beta exchange-traded fund popularity is soaring as investors look for new ways to beat the market. Funds pulled in $43 billion in assets last year alone, according to Bloomberg, and are breaking records so far this year.

But some critics are questioning whether these newfangled funds are really as smart as they seem. They can be costlier, riskier and more complex than plain-vanilla ETFs that simply mirror an index such as the S&P 500, say critics.

An offshoot of value investing, these smart beta funds are meant to right index efficiencies that are usually tilted toward big stocks with outsized market capitalizations, like Apple or Exxon Mobil. When one of these titans' stock price slides, index performance can get pushed down faster than when a small stock falls, because they make up a smaller portion of the index.

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Using an active-management strategy, smart beta ETFs try to leapfrog these weaknesses by choosing stocks based on various factors, like dividends or stock market valuations, which can bolster indexes.

Some experts argue that these smart beta strategies help funds outperform the market over time — or can help investors fine-tune a portfolio strategy. "These ETFs offer investors more choices," said Tom Lydon, president of Global Trends Investments. They can rebalance a portfolio, he added, which investors may find harder to do on their own.

Other experts quickly added that Wall Street is littered with supposed market-beating strategies that have failed over time.

"Smart beta ETFs are marketed as some sort of Wizard of Oz," said Rick Ferri, founder of Portfolio Solutions and author of six investment books. "And it's not true. There is no free lunch."

Read MoreSmart beta: Beating the market with an index fund

For starters, the funds aren't cheap, said Ferri. Investors will pay at least eight times more for them than for index-tracking funds, he said. Take the Vanguard Total Stock Market ETF. This fund tracks the investment return of the overall stock market and sports a low .05 percent expense ratio. Conversely, smart beta ETFs like the PowerShares S&P 500 Buy/Write Portfolio has a .75 percent expense ratio. Higher expense ratios can ding returns, experts claim.

Despite higher fees, smart beta funds are still cheaper than actively managed mutual funds, countered Lydon, who also added that the funds won't protect investors. And they're liquid, since you can buy and sell ETFs on a stock exchange.

Randy Kurtz, chief investment officer at RK Investment Advisors in New Jersey, prefers low-cost ETFs, like the iShares S&P 500 Value Index or iShares S&P 500 Growth Index, which each have .18 percent expense ratios. There are also dozens of value-focused ETFs that are currently offered.

Read MoreEmerging market ETFs are on a tear—here's why

Another downside is that smart beta ETFs can use risky strategies. Some of them, such as low-volatility ETFs or functionally weighted ETFs, are sector heavy, explained Ferri, and others may invest mainly in small-cap stocks. "You'll always be taking more risk to get higher returns," he said.

Or the funds may use complicated options or futures or borrowed money, which can send funds spiraling down faster than an S&P 500 decline. "We're talking about a motley group of strategies," said Ben Johnson, director of passive funds research at Morningstar. "It's important that investors understand the diverse number of processes."

The dilemma for investors is knowing what smart beta metric to choose. Going for, say, stable year-over-year earnings in a stock, said Kurtz, means that you'll miss investing in companies like Google or Facebook when they're exploding. "There's no secret formula," he added, "that can work every time."

And more risk doesn't always translate into higher returns, say critics. Just as smart beta fund strategies vary widely, so do returns. Some smart beta funds have underperformed the S&P 500, despite higher expense ratios. Other smart beta funds, such as the Guggenheim S&P 500 Equal Weight fund, regularly outperform the index. The fund has risen 25 percent in the past year vs. 21.1 percent for the S&P 500; long-term numbers are even more impressive: 164.9 percent vs. 120.5 percent for the S&P 500.

"What will you do if the fund underperforms?" asked Ferri. Will you end up selling it at the wrong time and moving into the next smart thing? The real risk, he said, "is not holding on to the funds through good and bad cycles, which can take up to 25 years." And for most people, that's not a practical option.

Tracking actual smart beta fund performance can also be tricky. Some fund-tracking data comes from back-testing, which estimates performance of a strategy by going back in time to see how it would have worked. However, some experts think this method is fool's gold, since it doesn't rely on actual historical data. "Oftentimes the index that gets launched is the best of bad back tests," said Johnson. "Past performance is not indicative of future performance."

This is rearview-mirror investing, added Kurtz. "It's harder to tell how an investment will perform without a full market cycle," he said.

"There's no magic formula that can work time in and time out," he added. "Stay away from high-priced flavors of the month."