How ‘Smart Beta’ Funds Outperform the Market

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

Some things just get better with age.

Other predictions prove prescient, confirmed with the benefit of 20:20 hindsight.

Both of these clichés apply to my views on the recent explosion in “smart-beta” exchange-traded funds (ETFs).

First, over the past several years, “smart-beta” ETFs just keep getting both better and smarter. New strategies continue to emerge that are consistently outperforming traditional, market-cap-weighted indexes.

Second, the trend toward better and smarter in the ETF world is something I expected would take firm hold of the investment community. What was dismissed 18 months ago as a passing fad is the driving force behind ETFs overtaking hedge funds in terms of assets.

Back in November 2013, I gave a presentation, “Why Smart Beta is Intelligent Investing,” to a group of elite financial advisors in London.

I summarized my speech at that time in an issue of The Global Guru.   (You can download a copy of the actual presentation by clicking here.)

At that time, I told my audience that smart-beta ETF assets had grown an astonishing 43% during the first nine months of 2013 versus 16% growth in total ETF assets. I also wrote that these funds had attracted $45 billion in new investment during 2013.

Fast forward 18 months, and smart-beta ETFs remain all the rage in the investment world, proving that in terms of marketplace popularity — “smarter” truly is better.

A Banner Year for Smart Beta

According to data from Invesco PowerShares, 2014 was a landmark year for both the ETF world in general and for smart-beta ETFs in particular.

The data shows that smart-beta ETFs accounted for more than 17% of net domestic ETF inflows in 2014. That’s a remarkable statistic when you consider that smart-beta funds represent less than 11% of the total ETF asset pool.

At last count from Invesco PowerShares, there were about 350 smart-beta ETFs available to U.S. investors, and the total value of those assets is more than $230 billion. That figure is up from a mere 212 smart-beta funds in 2010 that had less than $65 billion in assets.

Smart-beta ETFs now have become popular among the general investing public, and not just with savvy investors and “early adopters” like yours truly who saw their value years ago.

Today, institutional investors, public and private pension and endowment managers and all sorts of professional money managers rely on smart-beta funds to be, well, “smarter” than the market.

So, what are smart-beta funds, how do they work — and why do I think you should be invested in them?

The Heart of Smartness

I wrote the following when describing smart-beta funds in the aforementioned Global Guru issue dated November 26, 2013.

Traditional index funds provide investors exposure to the performance — or beta — of any market. The strategy is straightforward. You buy all of the securities in an index and weight them based on their size or market capitalization.

Index fund evangelists like John Bogle of Vanguard point out that active managers are unable to outperform the market consistently. In addition to outright lack of skill, the combination of high fees and excess trading are a drag on fund performance.

Smart-beta ETFs offer a clever solution to this conundrum by giving investors the opportunity to outperform the mainstream market indexes, while retaining the benefits of traditional indexation.

Because traditional index funds are based on market-cap-weighted indexes, the underlying ETF — say for example the SPDR S&P 500 ETF (SPY) — provides exposure to the same weighting as the S&P 500.

That means you get a whole lot of the top-three-weighted companies in the index. In the case of SPY, those three big holdings are Apple (AAPL)Exxon (XOM) and Microsoft (MSFT).

In contrast, “smart-beta” ETFs are invested based on some sort of alternative index which is not market-cap-weighted.

To break it down:

“Smart” means that you are invested simply in an “alternative” or “non-traditional” index.

“Beta” confirms that you are still investing in a passive index, and not in the discretionary judgment of a single manager.

The Smart Winners in 2015

While I think smarter is almost always better in life, when it comes to investing in smart-beta ETFs, you only need to look at the numbers to convince yourself.

So far in 2015, three smart-beta ETFs I am invested in both personally and on behalf of my clients are trouncing their traditional market-cap-weighted ETF counterparts.

Let’s use the aforementioned SPDR S&P 500 ETF (SPY) — a passive market-cap-weighted index-based ETF — as a benchmark.

Year to date through May 4, SPY is up 2.81%, and it is up 14.56% over the past 12 months.

That’s better than a poke in the eye, but it’s not much to write home about either.

One smart-beta ETF doing far better is the Direxion All Cap Insider Sentiment ETF (KNOW). It is up 3.47% year to date (through May 4), and it is up 18.10% during the past 12 months.

Pegged to an index called the Sabrient All-Cap Insider/Analyst Quant-Weighted Index, KNOW invests in a 100-stock benchmark based on factors such as the amount of shares bought by company insiders; the percentage increase in each insider’s holdings; positive revisions in analysts’ forecasts; and the trend in earnings estimate revisions by analysts.

While this may seem complicated, the idea behind this smart-beta strategy is simple. It is all about owning stocks with big insider buying and strong insider sentiment.

Another, even stronger smart-beta ETF this year is the Guggenheim Spin-Off ETF (CSD), a fund up 5.54% so far this year. This ETF mirrors the Beacon Spin-off Index, which tracks companies spun off from a parent company within the past 30 months.

A “spin-off” here is defined as the distribution of stock in a subsidiary company by its parent company’s shareholders. It also can be an equity “carve-out” or “partial initial public offering” in which a parent company sells a percentage of the equity of a subsidiary to public shareholders.

So far this year, the performance of spin-offs in CSD have nearly doubled the performance of SPY.

Finally, there’s the First Trust US IPO Index Fund (FPX). This smart-beta ETF is up 7.6% year to date through May 4, and it is up 18.62% over the past 12 months, putting it near the top of the smart-beta ETF bunch this year.

As the name suggests, FPX is all about the initial public offering (IPO) market and tracks the IPOX-100 U.S. Index, which includes the 100 largest, typically best-performing and most liquid IPOs in the IPOX Global Composite Index.

This year, the strong performances of large holdings like Facebook (FB) and pharmaceutical Abbvie (ABBV) have helped propel FPX to the top of its class.

The bottom line?

The consistent outperformance of smart-beta funds in general confirms for me that yet again, smarter is usually — dare I say, always — better.

In case you missed it, I encourage you to read the e-letter column from last week about why Japan is still an attractive market. I also invite you to comment in the space provided below my commentary.

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