Don’t be charmed by the smart beta genie

The term "smart beta" conjures up an image of an all-knowing, all-powerful investment genie. This may help to explain why smart-beta funds have become increasingly popular over the past few years more than $150bn worth of investment has flowed into them since 2013, according to the Financial Times. But many people buying these products aren't exactly sure what they are paying for, or what risks they are taking.

So what is smart beta? Cynics would say that it's a neat marketing buzzword based on the concepts of "alpha" and "beta" beta being the return generated by the markets and alpha being the additional return (positive or negative) achieved by investors. And certainly the name is controversial in the investment industry. Many people prefer more sober terms, such as "factor investing", to describe what these funds do and how they differ from traditional passive funds.

Most passive funds are "cap-weighted", meaning that they just hold all the stocks in an index in proportion to their market value. So they hold more of higher-valued companies (for bond funds, they hold more bonds from those who have issued the most debt).

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Smart-beta funds choose and weight the investments in the portfolio based on a set of predetermined criteria (known as factors) that seem to outperform the market over the long term. At its simplest, a fund might just weight all companies equally. Others will use more complicated rules, such as choosing stocks with high dividend yields and low debt whose shares are less volatile than the market.

Hence smart-beta funds are sold as a best-of-both-worlds option: better returns than passive funds without the high costs of active management. About two-thirds of smart-beta exchange-traded funds (ETFs) have a management fee of less than 0.4%, says Ben Johnson of fund research firm Morningstar, compared to the average 0.93% for a large-cap equity fund. This all sounds great, as most fashionable investment products do.

But it's not as straightforward as that. The smart-beta boom has sent fund firms looking for more factors that outperform the market, so that they can be marketed to investors in flash new products.However, the fact that many of these appear to have worked in the recent past doesn't mean they will do in future.

Indeed, of the hundreds of factors that have now been published in research papers, only a handful have been shown regularly to beat the market over time and across different countries. These include value (cheap stocks), momentum (shares that have been going up), low volatility (less volatile shares) and possibly size (smaller companies) and quality (those with consistent earnings and strong balance sheets).

So anybody looking at a smart-beta fund should stick to simple strategies where there is plenty of independent evidence that they work. Avoid complicated ones that may have risks that are not immediately obvious (they may perform well during normal conditions, but post catastrophic losses during a crisis).

Next, be aware that many factor ETFs are niche products that can be fairly illiquid and expensive to trade. Stick to liquid funds only. Last, ETFs based on major factors have been around for years.So make sure you're not just going for some novel, well-marketed fund when there's something established and cheap that essentially does the same job.