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May 8, 2015, 11:17 a.m. EDT

Use Smart Beta to beat the index funds

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About Nicholas A. Vardy, CFA

Nicholas A. Vardy is Chief Investment Officer at Global Guru Capital, a fee-only, SEC-registered investment-advisory firm where he manages money for high-net-worth clients. Vardy is also the editor of three investing and trading services at NicholasVardy.com. He appears regularly on the Fox Business Network and CNBC Asia, and is a highly-rated speaker at investment conferences around the globe.

Nicholas regularly contributes his market views on his company blog. You can also follow Nicholas on Twitter @NickVardy or email him at nvardy@globalgurucapital.com.

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By Nicholas A. Vardy, CFA

The "smart-beta" exchange-traded fund (ETF) revolution is upon us.

What was dismissed 18 months ago as a fad is now the driving force behind the growth in ETFs, which themselves are on the verge of overtaking hedge funds in terms of assets under management.

Back in November 2013, I gave a presentation, "Why Smart Beta is Intelligent Investing," to a group of elite financial advisors in London. (You can download a copy of that presentation by clicking here .) My thoughts were greeted with thinly veiled skepticism by the conservative financial advisor community, especially when I revealed that I actually used smart-beta funds to invest on behalf of clients.

At that time, I told my audience that smart-beta ETF assets had grown an astonishing 43% during the first nine months of 2013 vs. 16% growth in total ETF assets. I also said that these funds had attracted $45 billion in new investments during 2013.

Fast forward 18 months, and smart-beta ETFs remain all the rage in the investment world, proving that in terms of marketplace popularity, "smarter" truly is better.

Smart beta: A banner year

According to data from Invesco PowerShares, 2014 was a landmark year for both the ETF world in general and for smart-beta ETFs in particular. Smart-beta ETFs accounted for more than 17% of net domestic ETF inflows in 2014. That's a particularly impressive statistic as smart-beta funds represent less than 11% of the total ETF asset pool.

At last count, there were about 350 smart-beta ETFs available to U.S. investors, with a total value of more than $230 billion. That figure is up from a mere 212 smart-beta funds in 2010 that had less than $65 billion in assets.

Today, institutional investors, public and private pension and endowment managers as well as professional money managers rely on smart-beta funds to be, well, "smarter" than the market.

Smart-beta ETFs are also becoming popular among the general investing public, and not just among the early adopters who recognized their value years ago.

The heart of smartness

So just what are smart-beta funds?

Traditional index funds provide investors exposure to the performance — or beta — of any market. The strategy is straightforward. You buy all the securities in an index and weight them based on their size or market capitalization.

Index-fund evangelists like John Bogle of Vanguard point out that active managers are unable to outperform the market consistently. In addition to outright lack of skill, the combination of high fees and excess trading are a drag on fund performance.

Smart-beta ETFs offer a clever solution to this conundrum by giving investors the opportunity to outperform the mainstream market indexes, while retaining the benefits of traditional indexation.

Because traditional index funds are based on market cap-weighted indexes — say, for example, in the SPDR S&P 500 Trust ETF /zigman2/quotes/209901640/composite SPY +2.48% — you get a lot of the top-three weighted companies in the index. In the case of SPY, those three big holdings are Apple /zigman2/quotes/202934861/composite AAPL +6.98% , Exxon /zigman2/quotes/204455864/composite XOM +0.21%  and Microsoft /zigman2/quotes/207732364/composite MSFT +2.81% .

In contrast, smart-beta ETFs are invested based on some sort of alternative index which is not market-cap-weighted.

US : U.S.: NYSE Arca
$ 441.95
+10.71 +2.48%
Volume: 164.09M
Jan. 28, 2022 4:00p
US : U.S.: Nasdaq
$ 170.33
+11.11 +6.98%
Volume: 179.67M
Jan. 28, 2022 4:00p
P/E Ratio
Dividend Yield
Market Cap
$2600.76 billion
Rev. per Employee
$ 75.28
+0.16 +0.21%
Volume: 30.58M
Jan. 28, 2022 4:02p
P/E Ratio
Dividend Yield
Market Cap
$318.03 billion
Rev. per Employee
US : U.S.: Nasdaq
$ 308.26
+8.42 +2.81%
Volume: 49.71M
Jan. 28, 2022 4:00p
P/E Ratio
Dividend Yield
Market Cap
$2247.86 billion
Rev. per Employee
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