Smart Beta: Not Your Father’s Index Fund

Northern Trust and State Street Global Advisors are leading the charge among large index fund providers to offer a more active alternative.


With investors throwing the bulk of their new money at index funds, traditional asset managers have been fighting back with smart-beta products. Smart beta, as the name suggests, is a hybrid: part actively managed fund, part index tracker. Smart-beta vehicles, which typically track a customized index or offer an investor exposure to a range of style factors, like value or momentum, now command $285 billion in institutional assets, up from $58 billion in 2010, according to research firm Morningstar.

Smart-beta offerings are a nod to investors’ increasing appetite for low-cost passive funds. For asset management companies they provide a higher-fee alternative to the traditionally dirt-cheap products that track popular indexes like the S&P 500. Because smart-beta funds are constructed using algorithms, fund companies can manage billions of dollars as cost-effectively as they oversee much smaller sums. Management fees on smart-beta products range from 30 to 100 basis points, compared with the 5 to 10 basis points that big investors generally pay for a standard index portfolio. Money managers are winning converts: Assets in Northern Trust Corp.’s engineered equity — as the firm calls smart beta — nearly doubled, from $4.7 billion to $8.5 billion, in 2013.

The S&P 500 has long been the de facto standard index for many passive funds. But that decision wasn’t based on research that found the S&P the best way to create market exposures for investors. “Forget the economics of this for a minute,” says Adam Patti, CEO of IndexIQ, who founded his firm in 2007 primarily to offer smart-beta funds, including exchange-traded products that replicate the investment returns of different hedge fund strategies. “Market-cap-weighted indices like the S&P 500 were never designed as an investment product,” he notes. “They were simply market indicators.”

Not all smart beta is so smart, asserts Patti. A low-volatility fund, for instance, might just load up on utility stocks. Before IndexIQ, Patti ran Fortune Indexes, which in 2000 teamed up with State Street Global Advisors to launch an exchange-traded fund based on the Fortune 500 ranking of the U.S.’s biggest companies by revenue.

Scott Powers, CEO of Boston-based SSgA, says the simplest way to think about smart or alternative beta is as a means of getting away from indexes that weight companies based on market capitalization. As one of the largest providers of index funds, SSgA can instead construct indexes to reflect a company’s financial strength, its ability to pay dividends, the volatility of its shares or any other measure. This way, SSgA can offer a true alternative to active managers, many of which haven’t beaten their benchmarks over time.

“I can build you a portfolio with the same style characteristics as you would get from an active manager, but it will have indexlike fees,” says Powers, whose firm markets such products as advanced beta. “Isn’t that a better mousetrap?” State Street recently launched a series of smart-beta ETFs and is also offering customized funds for larger institutional investors. “Low-return active managers charging high fees should be looking over their shoulders,” Powers adds.

In many ways, smart beta is in line with investors wanting not just distinct products but comprehensive advice from their money managers. Like actively managed funds, smart-beta products take a stand and don’t blindly follow popular indexes. J.P. Morgan Asset Management recently launched its first ETF, the J.P. Morgan Diversified Return Global Equity fund. CEO Mary Callahan Erdoes says her firm is taking its asset allocation modeling services and applying them to a smart-beta ETF. The fund is designed to provide global returns from four factors: value, size, momentum and low volatility. It was launched specifically as an alternative for investors in cap-weighted index funds that J.P. Morgan believes are systemically biased toward overvalued securities.

Vanguard Group, the largest index fund provider, has not jumped on the smart-beta bandwagon. CEO F. William McNabb III says his company has researched smart-beta products and found them to be a bet that a particular factor, such as value, will outperform the broader market. “Smart beta is a very inappropriate name for the category of funds it represents,” says McNabb. “True beta is the market’s performance. Smart beta is an active bet that is being implemented passively.” He says that if smart-beta funds look successful, it’s only because a factor is in favor at the time. Investors, he warns, need to understand the specific bets that are being made and the risks that they are taking.

Follow Julie Segal on Twitter at @julie_segal.

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