Advisor Insight

From 'smart beta' to 'factor-based,' parsing the active funds name game

Key Points
  • Whether called smart beta, strategic beta or factor-based, these active investment funds all try to beat the market, with either better performance or better risk management.
  • Rob Arnott, founder of Research Affiliates and widely credited with pioneering the concept of smart beta investing, thinks that term no longer has any meaning.
  • Many experts think the market for these types of funds, whatever they're called, has nowhere to go but up.

What's in a name? If it's smart beta, just about everything in the new investment product landscape.

Smart beta is the new face of active investment management, with new funds coming to market on a regular basis. Much of the billions of dollars flowing out of actively managed mutual funds is flowing into so-called smart beta funds.

Michael Blann | Getty Images

While definitions of these funds abound, as the name implies, they aim to beat the market (beta), either with better performance or better management of risks. They try to do that by tracking an index weighted according to factors other than market capitalization, such as dividend-paying policies, fundamental strength, value, momentum or low volatility. In other words, they try to do what active managers do, but in a rules-based, transparent and inexpensive way.

Since the financial crisis, the demand for these funds has exploded. Research firm Morningstar was monitoring 708 such funds, with $740 billion in assets, at the end of January. That compares to 213 funds managing $133 billion in 2009. "Investors are using these funds as a replacement for active strategies," said Alex Bryan, director of passive strategies research at Morningstar.

While smart beta is the commonly used label for these funds, Morningstar prefers the term strategic beta.

"Not all these strategies are smart," said Bryan. "Sometimes they work, and sometimes they don't."

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He added, "People need to evaluate them like they do active managers."

Rob Arnott, founder of Research Affiliates and widely credited with pioneering the concept of smart beta investing, thinks the term no longer has meaning.

"It's been stretched to encompass just about everything formulaic, with the result that a lot of dumb ideas are being called smart beta," he said. "It now spans just about everything, so the term effectively means nothing."

Vanguard, the market leader in low-cost index funds, has avoided the term smart beta entirely in its recent product offerings in the space. In mid-February the firm launched six new factor-based ETFs and one new factor-based mutual fund.

The funds target exposure to the factors of value, momentum, quality, low volatility and liquidity. A multifactor fund will combine the factors of momentum, fundamentals strength and value (low price to fundamentals).

"We think we've hit the biggest, most robust factors that investors can use predictively," said John Ameriks, head of Vanguard's Quantitative Equity Group, which will manage the funds. Always skeptical of investment product proliferation, it plans to stick with this lineup. "If there is demand for a broader set of [factor funds], we'll consider it, but we have no plans to enhance this suite," Ameriks said.

Vanguard took its time coming to market with its funds, in part because it didn't apply for exemptive relief with the Securities and Exchange Commission as an index fund, as many smart beta offerings do. "This is actively managed investing, and people need to think of it like that," said Ameriks. "Investors need to understand the strategies the same way they analyze active managers."

Vanguard also wanted to provide context for investors by simultaneously launching a website with educational material on how to use the funds to achieve financial goals. As always, Vanguard is throwing the gauntlet down to the rest of the industry in terms of cost. The single-factor funds carry an expense fee of 13 basis points — a fraction of the cost of most smart beta funds. The fee on the multifactor fund is 18 points.

"Active returns have always come from emphasizing factors," Ameriks said. "These funds enable people to get them at a much lower cost."

Smart beta offerings will keep coming to market, and choosing among them will only get harder. Most of the existing funds have no meaningful track record. The fund marketers happily provide backtested results for the strategies the funds pursue, but investors need to be wary.

"We encourage people not to put a lot of faith in back-tested results," said Bryan at Morningstar. "Companies can tweak their models to get the results they want."

Bryan nevertheless expects the market for these funds to continue growing rapidly. The fund companies like them because they can charge a higher fee than simple index funds. Investors like them because they are less expensive than actively managed mutual funds yet still provide the opportunity to beat the market.

"Investors still want to do better than average," said Bryan. "If these funds deliver, the flows will follow."

Any time trillions of dollars is being invested in the same strategies, they won't work for long. Buying what has performed well in the past almost guarantees poor performance.
John Arnott
founder of Research Affiliates

Therein lies a potential pitfall for investors. It's a boilerplate disclaimer, but past performance is not indicative of future results. In fact, it's very often the opposite, as outperforming strategies tend to revert to mean over the long run.

"Every factor except value is currently trading at a premium to market," said Arnott at Research Affiliates. He argues that momentum investing, the best performing factor last year in a surging market, has added no value for investors over a 10-year period thanks to the momentum crash of 2008-09. Investors looking to jump into the hottest strategies could be setting themselves up for disappointment.

Arnott suggested investors have to take a high-level value perspective on factor investing strategies that they're considering.

"Any time trillions of dollars is being invested in the same strategies, they won't work for long," he said. "Buying what has performed well in the past almost guarantees poor performance."

— By Andrew Osterland, special to