You can beat the market, but when you factor in the cost of doing it, it's not worth the effort. That's essentially the argument for passive investing strategies that simply track a market index rather than trying to pick investment winners from a pool of candidates.
There is something very basic and aspirational about doing better than average, however. For investors who like the low-cost, easy-to-understand nature of index investing but still want to try to beat the market, "smart beta" funds offer increasingly diverse strategies to attempt it.
Smart beta is an investment style where a manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market.
"There's been a shift away from the active management model toward investors taking ownership of the outcomes they get from investing," said Jason Hsu, co-founder of Research Affiliates and a pioneer in smart beta investing. "Smart beta funds offer lower fees, better transparency and more control for investors."
But does that make them smart?
Fund research company Morningstar prefers to use the "strategic beta" moniker to describe the bucket of exchange-traded funds — and a very small number of mutual funds — that employ some form of modified indexing strategy.
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"There's just too many positive connotations to the smart beta label," said Ben Johnson, director of global ETF research at Morningstar. "They're not all smart, they won't look smart all the time, and investors don't always use them intelligently."
They are, however, increasingly popular with investors, and fund companies are rushing products to market. At the end of June, there were 444 strategic/smart beta ETFs in the market managing about $450 billion, according to Morningstar data. That's up from 213 funds managing $132.5 billion in assets in 2009. They now account for 21 percent of all exchange-traded products and about 31 percent of all cash currently flowing into the industry.
"We expect to see this growth continue," said Johnson.
Smart beta funds straddle the worlds of active and passive investment management. The active element comes with the design of the product. Traditional index-based funds are weighted according to the market capitalization of the components.
That creates a bias toward the most highly valued companies in the market, or in the case of fixed-income markets, the most indebted, industry observers say. If an investor believes in the efficiency of markets, market cap-weighting is the only truly passive investing model.
Smart beta funds, in contrast, weight their portfolios using factors other than price. Some weight according to fundamental factors, such as sales growth or profitability; others use book value or dividend payouts. Still others set up rules focused on price momentum or low market valuation. The implementation of the strategy is the passive element, as portfolios rebalance automatically according to the rules of the model.
"We think of smart beta as an implementation route for investors," said Fabio Cecutto, head of global equity investing at consultant Towers Watson. The firm is generally credited — or blamed — for inventing the smart beta label.
"If they [investors] don't believe that market-cap investing is efficient, they can get a manager to try to add value or they can apply a rules-based strategy that plays to behavioral biases or inefficiencies in the market," he added.
The big advantage of smart beta funds over active managers is cost. About 66 percent of smart beta ETFs have a management fee of less than 40 basis points, Johnson said.
That's significantly more than most market-weighted index funds, but significantly less than the 0.93 percent that the average active manager of a large-cap equity fund charges annually. "Some one-third of these funds have fees over 0.4 percent," said Johnson. "Regardless of the strategy, you want to make sure it's investable at a low cost."
On Sept. 17, Goldman Sachs Asset Management entered the smart beta market, launching the Goldman Sachs ActiveBeta U.S. Large Cap Equity Index with a 0.9 percent net expense ratio, compared to 0.38 percent for the average smart beta ETF.
Like all good ideas on Wall Street, however, smart beta funds are being marketed to death.
There are thousands of factors and combinations of factors that might arguably generate investment returns better than the market, but very few of them have track records that can support the claim. While back-testing of a rules-based strategy might look great, there's no guarantee on future performance.
"Some product providers saw smart beta as a new way to extract higher fees," said Research Affiliates' Hsu, whose firm began licensing its fundamentally weighted index products to companies such as PowerShares, Pimco and Schwab in the mid-2000s.
"They add bells and whistles to the product to differentiate themselves and make it harder for investors to understand the strategy," Hsu said.
Experts say there are basically just a handful of factors that should serve as models for smart beta products: fundamentals, value, momentum and possibly low volatility, and there are hundreds of variations therein to launch new products. Johnson suggests that before investors jump into a hot new multifactor strategic beta fund, they make sure they understand what the strategy is.
"There are asset managers rolling out newfangled, complicated strategies and charging higher fees for them," he said. "Investors need to think long and hard about whether they're getting good value."
—By Andrew Osterland, special to CNBC.com