Why you should care

Because smart investing is what all of us should be doing.

To get an edge on the stock market in a world where smart TVs, smart watches and smart thermostats are all the rage, obviously investors would want to buy a “smart” financial product, right?

Well, that’s just one of the reasons so-called smart beta products are taking off. They went mainstream in a big way this spring when the financial firm Charles Schwab included its own version of smart beta with the launch of an automated investment platform called “intelligent portfolios.” (Yeah, we all want intelligent stuff too.) All told, smart beta funds total $567 billion under management, which is more than double the amount compared with 2012, according to fund research company Morningstar, which calls the products “strategic beta.”

But here’s the thing: Smart beta’s the latest Wall Street innovation that might not prove all that useful (from an industry with a long history of such products). And, get this — few actually agree on exactly what the hell these products are. “Smart beta is one of the most popular phrases in financial lexicon, and the least well-defined,” says Todd Rosenbluth, senior director at S&P Capital IQ, a market research firm. What’s more, every professional I interviewed hated the term and started by asking how I defined it — you know, just to be sure we were talking about the same thing. Basically, they’re investment products tied to the performance of an index of stocks based on something besides market capitalization (industry jargon for the total value of a company), which could include dividends or revenues, for instance. Now, whether these products are smart … that’s a matter of opinion.

With smart beta, you are not relying on some all-star with a 30-year track record. You are relying on data that can be tested.

Dave Donnelly, chief executive at Strategic Alpha

First, take a look at popular “market cap” index funds. These are based on Standard & Poor’s 500 index, which assigns companies with large market valuations (aka market cap) more “weight” in the index. So, for instance, tech behemoth Apple, with a market valuation of $710 billion as of Friday, would account for about 4 percent of a portfolio invested in a market-cap index. In an unweighted index, by contrast, every stock — including smaller companies — has equal weight. Apple would make up just 0.2 percent of a portfolio invested in such an index.

Such indexes, in effect, are more sensitive to the stock prices of smaller companies, which some say tend to grow faster over the long run. Sure, there’s a lot of academic theory packed behind many of these smart beta products. But, basically, the idea is to establish a middle ground between ultracheap funds based on the total value of companies, while promising to deliver the elusive higher returns sought by old-fashioned stock pickers, whose management fees tend to be higher — often high enough to wipe out any superior performance.

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Then there’s smart beta, which uses a lot of math and historical simulations — so-called backtesting — to pick stocks while still charging relatively low management fees. “With smart beta, you are not relying on some all-star with a 30-year track record. You are relying on data that can be tested,” explains Dave Donnelly, chief executive at Strategic Alpha, a stock-rebalancing advisory service, who’s a big proponent of the funds. For its part, Schwab has actually ditched the term smart beta altogether — the company calls it “fundamental indexing” instead, like that’s any better. These products aren’t weighted by market cap or stock price but by the size of investment in a company according to sales, cash flow or dividends. In this model, the company with the biggest dividend payout might be the largest company in the index.

But is this just the latest triumph of financial buzzwordiness over substance? Schwab, of course, cites research that shows these sorts of strategies have outperformed index funds by 1 or 2 percentage points a year — although not every year. Schwab also argues that including these products may help cushion returns when the market falls. Yet critics say indexes like these, when they work, are nothing new, just replicating known patterns in the market. Bhanu Singh, vice president of portfolio management at Dimensional Fund Advisors, a fund management firm, warns that many smart beta strategies are simply untested in the real world, regardless of what company models show. “I haven’t seen a bad simulation yet,” Singh says. (Yes, he’s being ironic.)

Others worry about the higher cost of these kinds of products compared with ultracheap traditional funds. And then there’s the complex design of some products, which makes them hard to select and compare. “For a normal person who’s not in this every day, it’s a nightmare,” says Donnelly. Ben Johnson, who tracks these products for Morningstar, says investors should pay attention to the company sponsoring the product and to the index design and to be sure the fees are low. And, as many investors often “forget” or discount, there’s that time-honored dictum that past performance is no guarantee of future results.

Still, some claim smart beta can help reduce sharp increases or drops in investments, even if higher returns don’t materialize. And history shows that most individual investors sell stocks at the wrong time — when the market falls. If a lesser fall encourages more investors to just stay put, they’ll likely do better. Now that’s smart.

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