How active is your passive?

The good old days, when you used a phone to call people, you could wear shoes through airport security, and ETFs simply tracked a broad index of stocks or bonds.

ETFs, or exchange-traded funds, have long been the cheap, boring building blocks of MoneySense’s Couch Potato portfolios. The older and best-known ETFs simply hold all the stocks in a popular index, such as the S&P/TSX 60, which includes the 60 largest companies in Canada, or the S&P 500, which includes the biggest U.S. stocks. ETFs with more creative strategies are hardly brand new, but today specialized funds are no longer on the fringes.

Just about every ETF provider is getting into the game, launching new funds that promise to improve on plain-vanilla index ETFs. Collectively, many of these alternative ETFs have been dubbed “smart beta,” and they’re the most significant trend the industry has seen in years.

Of course, most new financial products are not designed to benefit Joe and Jane Investors: They’re mainly designed to put your money into the pockets of their creators. So are smart-beta ETFs really worth adding to your portfolio? We’re skeptical, but willing to keep an open mind. Here’s our assessment.

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Get smart about beta

Let’s start by unpacking the language. What exactly is beta anyway, and what’s so smart about it?

In finance, beta is a measure of risk: A stock with a high beta is more sensitive to the stock market’s ups and downs than one with a low beta. And because an index fund is designed to mimic the performance of the overall market—no more, no less—people sometimes describe this strategy as “capturing beta.” At the other end of the spectrum are active investors, who try to outperform the indexes by picking stocks or timing the market. They are said to be looking for “alpha,” the excess return over and above the performance of the benchmark.

Smart beta falls somewhere in the middle of these extremes. Academic research now suggests there may be ways to outperform a simple index fund by investing in stocks with certain characteristics (we’ll describe these in a moment). As a result, many new ETFs use indexes that screen for these stocks using a set of rules. Yes, they’re looking to do more than simply capture beta, but it’s going too far to say these ETFs are looking for alpha in the traditional sense, because there’s no superstar manager with a secret sauce making the specific decisions.

The term “smart beta” itself is contentious. “If you call something smart beta, that implies there’s also dumb beta,” says Paul Kaplan, director of research at Morningstar Canada, “and there’s nothing dumb about plain broad-market indexing. So we want to remove the value judgment.” Morningstar prefers the term “strategic beta.”

Investors should understand that smart beta, even if it is grounded in empirical evidence, has much to do with marketing. No one is clamouring to launch old-school index ETFs these days: They would need to compete with enormous, well-established names such as Vanguard and iShares, who can charge minuscule fees because they manage hundreds of billions in assets. If you’re going to launch a new ETF, it makes more business sense to promise index-beating returns and charge higher fees.

That said, while smart-beta ETFs are more expensive than the Couch Potato products of yore, they are a lot cheaper than traditional active funds, which routinely carry fees of 1% to 3%. Smart-beta ETFs typically have fees in the range of 0.15% to 0.75%, which means they only need a small edge to outperform.

Just the factors, ma’am

Now that we understand the general idea behind smart beta, let’s get more specific. Smart beta ETFs are designed to target what are called “factors,” or shared characteristics that can help explain the risk and return of a group of stocks. We’ll look at the specifics in a moment, but this term is jargon for things like low price, small company size, and patterns in price movements. Decades of academic research have shown that these factors have led to outperformance over the very long term (decades, at least) and in almost all countries.

These are the ones you’re most likely to encounter on the ETF menu. (Here’s a list of ETFs that promise exposure to these factors.)

Value. Value investing has its roots in the 1930s with pioneers such as Benjamin Graham, who was Warren Buffett’s mentor. But it was only in the 1970s and 1980s when studies confirmed that stocks priced cheaply relative to their fundamentals delivered higher returns than the overall market. There are several ways to define a value stock, but the most common measures are low price-to-book and price-to-earnings ratios. Stocks with high dividend yields are sometimes also lumped in with value stocks.

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Size. The bigger, the better? Not when it comes to stock returns. Since the 1980s, research has shown that small companies (or “small caps”) delivered higher returns than large companies over the very long term. The cut-off varies depending on the market, but it is typically a market capitalization of $2 billion or less.

Momentum. What goes up must come down—but maybe not right away. There’s plenty of evidence that when stocks rise in price they continue that trend for months before eventually settling back to earth. Likewise, stocks that have recently fallen in price tend to keep dropping in the medium term. The sweet spot for these trends seems to be longer than two or three months, but less than one year.

Low volatility. Most investors take it for granted that risk and return are related, so slow-and-steady companies might be expected to deliver lower long-term returns than highly volatile stocks. But the evidence suggests the opposite. Low volatility stocks actually tend to outperform—if not earning higher returns, then at least similar returns with less risk.

Quality. This newly identified factor is hard to explain: Low-debt, profitable companies tend to outperform. While that might seem obvious, it’s not, because these high-quality companies should be expected to have higher stock prices. Yet there’s evidence they have delivered outsized returns even if they’re not cheap.

So what kind of outperformance can you expect from tapping into these factors? That depends, but the promises are tempting. In the U.S., large value stocks outperformed the S&P 500 by more than two percentage points annually from 1935 through 2015 based on data from Dimensional Fund Advisors. During those same 80 years, small caps beat large caps by 2.8 percentage points annually. Data from the UK going back 50 years found similar numbers for small companies: A 2.9 percentage point edge since 1965.

As for momentum, the numbers are even more enticing. With data going back to 2001, the Morningstar Canada Target Momentum Index reports an annualized return of 13.6% as of August, compared with 5.8% for the broad market. Its international version did even better, outperforming by more than nine percentage points annually, while lagging its benchmark only once in 15 years.

What could go wrong?

So, now that you’re licking your chops in anticipation of all those index-beating returns, it’s time for a more critical look. As with many investing strategies, there’s often a yawning gap between theory and practice, and smart-beta ETFs face a number of challenges tapping into these factors.

Higher costs and taxes. Traditional index ETFs are not perfect, but they are ridiculously cheap: you can now get “dumb beta” with fees as low as 0.03% to 0.05% in Canada and the U.S., and even international equity ETFs are available for less than 0.10%. They are also extremely tax-efficient: Most have very little turnover, which means they rarely pass along capital gains to their investors.

Smart-beta ETFs are cheap compared with active mutual funds, but they can carry management fees above 0.50%. And because of their active nature they tend to have greater trading costs, which can also result in taxable capital gains. That means even if a smart-beta index manages to outperform before costs, the ETF might still lag once you account for fees, transactions and taxes.

You might not get what you expect. One of the challenges with smart-beta ETFs is knowing what’s under the hood. Many ETFs have similar sounding names, but they use very different strategies. As a result, their performance can vary in unpredictable ways.

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Consider two value ETFs now available in Canada. The iShares Canadian Value Index ETF (XCV) chooses companies according to ratios like price-to-earnings, price-to-book and dividend yield. It holds 55 companies and is heavily skewed to the big banks. Meanwhile, the First Asset Morningstar Canada Value Index ETF (FXM) uses a completely different methodology to choose its 30 stocks, and the Big Five banks are not among them. In 2013, FXM returned over 27%, compared with 15.2% for its iShares counterpart. But as of late September, XCV was up 6.5% annually over the previous three years, while FXM had returned 1.7% annually over the same period.

Are you attracted to low-volatility ETFs to smooth out the ups and downs of the stock market? The good news is you can choose from the offerings of PowerShares, BMO and iShares. The bad news is each one uses a unique strategy with divergent results. Over the last three years, the Canadian versions of these ETFs posted annual returns of between 11% and 17%, a very wide range for a group of funds purportedly capturing the same factor.

The point is that when you choose a smart-beta ETF, you may not really understand what you’re buying. “These things are very technical,” says Kaplan, “and if it’s not what you do for a living it’s hard to understand the differences between this strategy and that one.” In some cases, the strategies are not even disclosed publicly. With little else to go on, confused investors may simply choose the ETF that had the highest returns over the last year or so, which is a recipe for disappointment.

The factors may not persist. Just about all smart-beta indexes are based on past performance that may not continue in the future. For example, researchers noticed the outsized returns on small-cap stocks long before online brokerages and ETFs drove down stock transaction costs. Now that average investors can trade these stocks more cheaply and easily, that premium has shrunk, or even disappeared.

It’s also hard to explain why low-volatility or high-quality stocks should outperform—after all, less risk usually means lower returns. Same with momentum stocks: who wouldn’t want to chase what’s been hot and be rewarded with higher returns? Once these ideas get out, won’t investors gobble up these stocks, making these seemingly free lunches disappear?

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Smart beta can look dumb for a long time. While no one disputes that value stocks have outperformed over the very long term, it can take extraordinary patience to get through the inevitable rough patches. We’re not just talking about a year or two of disappointment. Growth stocks in the U.S. and international markets have outperformed value by between two and three percentage points annually over the last decade. Even more dramatically, the Russell 2000 (the most widely tracked benchmark for small-cap U.S. stocks) has lagged its large-cap counterparts since 1979. How many investors can tolerate those long periods of underperformance?

“People chase performance, so even if the product performs well over a full market cycle, investors may not have the conviction to stay with them,” says Kaplan. “That’s exactly what people have done with active management. ‘I’m going to use this manager until the fund starts going down, and then I’m going to switch to another.’ That’s a losing strategy.”

The jury is out

And so we’re left with cautious optimism for this new breed of ETF. As Kaplan has written, “Given the proliferation of strategic beta ETFs, it would be a mistake to discount them all in a single stroke. But it would equally be a mistake to accept all of them as good investments.”

If you’re currently a Couch Potato who has always used traditional index funds, getting seduced by smart beta is likely to do more harm than good. Once you convince yourself there’s something better out there, you’re liable to start second-guessing yourself. During any period where smart beta outperforms, you may be tempted to move all your eggs into that basket, only to be disillusioned when the pendulum swings the other way.

If you’re an active investor, however, smart-beta ETFs are certainly a better choice than an undisciplined stock picking strategy that’s based on little more than guesswork and hunches, and they’re a cheaper alternative to high-fee mutual funds. Long-term investors need to make an effort to understand the specific ETFs they select, and those choices need to be based on real conviction, not just recent performance. Investors also need to accept that there will be long periods of underperformance along the way. If you can’t endure those bumpy patches, you risk having smart beta turn you into dumb money.