Smart-Beta Investing

Smart Beta, ETFs, and Options

In January 1993 the American Stock Exchange released the first passively managed ETF, the S&P 500 Depository Receipt (the ticker symbol is SPDR and "spider" was adopted as its universally accepted nickname). The public investor loved this product and it soon became very actively traded.

Fifteen years later, in 2008 the U.S. Securities and Exchange Commission authorized actively managed ETFs.

Today, there are more than 1,900 different ETFs (exchange-traded funds) in the US alone.

Each was created by a company that believed the public would want to own such funds and that managing them would be profitable. The truth is that many ETFs had to shut down due to lack of interest. Yet new funds continuously appear on the scene.

As of year-end 2014, US investors owned $2 trillion worth of ETFs.

Smart Beta

Smart beta is a marketing term that infiltrated the world of exchange-traded funds (ETFs) more than a decade ago, says Eric Balchunas, Senior ETF Analyst at Bloomberg. Although the term "smart beta" is not original to ETFs, the industry has intelligently packaged this strategy, leading to spectacular growth. According to Morningstar, on Sept. 30, 2015, there were more than 450 US listed smart beta products, with a collective $510 billion in assets.

So what is "smart beta" investing?

From Wikipedia (paraphrased):

A smart beta portfolio is low-cost due to the systematic nature of its core philosophy; tracking an underlying index allows for cost efficiency (little trading is required).

Combined with optimization techniques traditionally used by active managers, the strategy offers risk/return potentials that are more attractive than a plain vanilla active or passive product. This combination places it at the intersection of efficient-market hypothesis and classic value investing.


The term smart beta is used to describe ETFs that consider anything other than market capitalization in weighing their holdings. Smart beta says you can outperform the basic market-cap-weighted index by selecting and weighting stocks by considering dividends, volatility, momentum, or revenue. An alternative is to weight each stock equally, giving greater representation to smaller companies. In short, there is no limit to the possible combination of metrics that can be chosen.

Smart beta fills the gap between active and passive management.

Smart Beta is defined as its own asset class. How that happened is an interesting story in itself. Over the last few years, a couple of trends were significant for the investment management industry: (1) Investors demonstrated how much they appreciate very small management fees and the transparency of ETFs (hurting the high-fee mutual fund industry).

(2) Money is, and has been available for investment. Many pension funds and personal retirement accounts are underfunded—especially when State governments owe billions of dollars to pension funds (see Illinois as an extreme example). Because investors like the concept of passive investing, and because many people do not want to sacrifice the possibility of earning more than an average market return, smart beta is very attractive.

Dan Draper Advice

Invesco's global head of ETFs, Dan Draper, offered guidance on smart beta investing. Below is an edited version of his thoughts.

  1. A smart beta investment strategy is designed to add value by strategically choosing, weighting and rebalancing the companies built into an index. For example, smart beta uses a series of rules-based screens to each stock in the index. Next, companies are ranked and weighted based upon these specific factors. 

    Traditional, passively-managed, indexes are based on market capitalization (i.e., the index consists of a bigger slice of large companies in the index—even when managers believe that the company is overvalued. Smaller companies are given smaller allocations, even when they are poised for growth.

    Smart beta gets around this "size of company" bias by weighting investments on objective, rules-based decisions, rather than a cap-weighted methodology.
  1. Smart beta indexes may target certain accounting metrics, such as dividends, cash flow, total sales and book value. Or, other metrics can be considered, such as low-volatility, momentum, or relative value—when modifying the stock portfolio. 

    Whenever these metrics are combined with an existing index, a new smart beta index is created. Hence, there are a huge number of possibilities. You can invest in any index that is modified by a manager whom you trust. And you may be able to find an Index with the specific modifications that you prefer.
  2. Smart beta ETFs, although passive, are still able to leverage active qualities through systematic rebalancing. One way to modify an index is to rebalance more frequently than the index itself does.
"Smart beta investments offer investors more options and should be evaluated based on each investor's investment objectives and time horizon."

Now a Note from a Naysayer

Rob Arnott is generally considered to be one of the pioneers of smart-beta investing. His recent paper, "How Can Smart Beta Go Horribly Wrong?" drew interesting commentary. For example, this from Dan Picasso for Barrons. Picasso's thoughts are summarized, and intermingled with mine, below:

Arnott targets newer factors chosen by active managers, such as “low volatility” and “quality” which have become more expensive in recent years and states that the relatively high valuations hurt an investor's probability of beating the market. He even fears that a "crash" of valuations could return these indexes to their historical valuations.

Picasso feels that the term “crash” sounds melodramatic, but agrees that the analysis raises concerns about the rapid pace of factor-based ETFs hitting the market. In fact, smart-beta ETFs accounted for more than one-third of new launches in 2015, a record high.The problem for investors is that the new ETFs may be fully valued.

The basic (and original) idea behind smart beta investing is to modify indexes by investing in factors that are underpriced. If newer funds are based on what is popular, then that is not compatible with the whole concept of smart beta ETF investing. For example, if an ETF places the extra weighting on dividend collection, then it will be difficult (if not impossible) to outperform the market when the universe of dividend-paying stocks is overvalued.

One of the major criticisms of factor-based ETFs is that they are constructed based on cherry-picked academic research that relies heavily on hypothetical, backward-looking returns. “The problem with the smart-beta area today is that there are a lot of products rolling out, and they all work, and "they all have wonderful back tests,” Arnott says. “That’s problematic if strategies are expensive.”

Consider a puzzling fact about stock performance over the past decade: The original factors—small size and value, whose outperformance investors such as Benjamin Graham, Kenneth French, and Eugene Fama spent decades validating—have actually been lackluster over the past decade.

  • The small-cap factor edged out large-cap stocks by only 0.6% in the one-year period ending in September 2015.
  • Value stocks trailed by 4.4%.
  • But, one of the newer factors, the least volatile stocks, beat the market by 2.7% annualized over the past decade
  • Shares of the most profitable U.S. stocks outperformed by 4.5% annualized over the past decade

Low-volatility ETFs have become popular with risk-averse investors because of their implied promise of matching the market performance of the benchmark index—with reduced risk. One such ETF, USMV (more on this fund below), received $3.5 billion in new cash in the first 4 months of 2016 and that is more than any other stock-based ETF. In other words, new money, even when investing in smart beta strategies, is following recent winners and ignoring the reasons why smart beta was invented in the first place.

Investors had to pay a premium for safety: Research Affiliates’ analysis shows that the least-volatile stocks recently had a price-to-book ratio of 2.49, or 44% above its 1.73 historical average (1967 - 2015). This represents a potential problem.

Another factor, “quality,” synonymous with profitability, had a book value of 3.43, compared with its 2.86 average over the past five decades. Arnott’s analysis shows that strong 10-year returns for both factors were derived almost entirely from stock-price appreciation without commensurate improvement in corporate fundamentals. The study shows that value-style strategies are pretty much the only ones that look cheap after the bull-market rally. BUT- that opinion may be biased: Research Affiliates’ (Arnott's firm) bread-and-butter strategy is closely aligned with value investing. They rigorously rebalance to trim strong performers and add laggards on the cheap.

PRF, the most popular Research Affiliates ETF, has a price-to-book valuation of only 1.8, considerably below the S&P’s 2.7, and the 3.2 for the S&P low volatility index. Will the typical valuation for value, low-volatility, and quality stocks revert to the mean, or will investors continue to plow money into the latter two categories? That is indeed the important question.

Just as the factors in favor now—low volatility and profitability—will probably fall out of favor in the future, no one knows when that will happen. One would assume that buying a single-factor ETF is either a bet on short-term performance or a commitment to hold for years. Otherwise, the risk of selling at exactly the wrong time is significant. [NOTE: Investors are notorious for buying at market tops and selling at market bottoms. The same holds when trading individual stocks, ETFs, and mutual funds.]

For instance, low-volatility ETFs can make sense for an investor with a specific view that choppy markets will persist. For those looking to hold for decades, a value ETF is a more prudent choice.

“Look before you leap,” Arnott says. “Past performance is just past performance. We should be smart enough to understand, and honest enough to look at, relative valuations.” True enough—but he is "talking his book" (i.e., his comments represent ideas that benefit his holdings).

Optionable Smart Beta ETFs

Most of the smart beta ETFs do not have listed options. However, if you search, you can find some that are. For example, iShares offers 48 smart beta ETFs, some of which have listed options.

This article provides a discussion about smart beta ETFs, including links that provide details about specific funds—that follow specific metrics. For example, if you are interested in dividends, FVD equal weights stocks that have a dividend yield higher than S&P 500 index. The fund also rebalances monthly. And it has options that trade on the CBOE. The problem is that there is very little interest in these options (i.e., volume and open interest are very low). Nevertheless, if you are careful when placing, you can adopt simple option strategies.

More on USMV

Matt Hougan, at, calls USMV the most important ETF of 2016. He offered a couple of reasons:

  1. The huge investor interest shows that smart beta ETFs can scale—and that is a crucial factor for fund managers. USMV is the largest true smart-beta ETF in the world and its success vaults smart beta into the mainstream and should embolden others to invest heavily into promoting similar products. 
  2. It demonstrates that second-to-market can win. USMV was not the first, and for many years was not the largest, minimum volatility ETF.

If smart beta investing is brand new to you, then use this article as a starting point. Do your due diligence before selecting which ETF to own and whether or not to adopt option strategies.