WisdomTree makes the case for its line of “smart beta” ETFs in the new whitepaper WisdomTree and Smart Beta. After explaining the concurrent rise of exchange-traded funds (ETFs) and passive indexing, the paper’s authors examine some of the shortcomings of using market capitalization to weight index components. Finally, the paper outlines WisdomTree’s unique approach to alternative indexing and the benefits investors and advisors can expect to receive from investing in WisdomTree smart-beta ETFs.
ETFs and Passive Indexing
According to WisdomTree, passive indexing based on market capitalization-weighted indexes was the breakthrough that led to the development and growth of the ETF industry. Indeed, ETFs took in nearly $241 billion in 2014, accounting for organic growth of 14%, and many top-rated financial believers believe ETFs may displace mutual funds within the next 10-15 years. Many of the world’s most popular ETFs are passively managed, cap-weighted index funds such as “SPY,” which tracks the cap-weighted S&P 500 Index.
But the case for passive indexing was dealt a massive blow by the 2008 financial crisis, during which time many supposedly “diversified” stock-and-bond portfolios experienced massive drawdowns. The primary justification for passive indexing is the efficient market hypothesis, which holds that all publicly available information is always reflected in a stock’s share price. But investment bubbles do occur, and market cap-weighted indexes inherently emphasize overvalued stocks, especially during frothy bull markets. This leads to steep declines when boom turns to bust.
The growing realization that the efficient market hypothesis may be an unsound investment theory has led to an increased emphasis on active management. Unfortunately for investors, this normally means higher fees. After all, passively managed, capitalization-weighted index funds require little of their managers and are thus able to charge low fees, whereas active management naturally means higher management fees. What’s more, actively managed ETFs are relatively new to the ETF world and there are far fewer actively managed funds available. This will likely change over the coming years, and will also be helped with the recent development of so-called exchange-traded managed funds (ETMFs).
Smart (Alternative) Beta
Luckily, investors seeking equity exposure without the pitfalls of passive indexing or the high fees of active management have a sort-of hybrid alternative: “Smart Beta” ETFs. These vehicles are also sometimes referred to as “alternative” or “strategic” beta, since they don’t generate the same “beta” that generally defines “market risk.” These products have passive management, in the sense that their management is “rules-based;” but they’re similar to actively managed products, since their composition bears little resemblance to a broad market index.
Every smart-beta whitepaper must begin with a definition of the controversial term, and the latest form WisdomTree is no exception. While many define “smart beta” as any type of index that isn’t capitalization-weighted, WisdomTree says there are four types of smart-beta strategies that are gaining the most attention. They are:
- Fundamentally weighted indexes, which weight components by a fundamental factor, such as earnings or dividends;
- Factor-based indexes, which select and weight components according to one or more fundamental factors, possibly dividing stocks into tiers and weighting them equally within the tiers;
- Equal-weight indexes, which give all components equal weighting within the index, regardless of market cap or other factors;
- Low-volatility indexes, which select and weight components on the basis of low historical volatility.
When it comes to identifying smart beta that’s actually smart, WisdomTree recommends investors look for the following five things:
- A rules-based, repeatable methodology that offers broad, representative exposure to an asset class.
- An alternative weighting method that allows for “ample investment capacity.”
- High correlations to established benchmarks.
- A proven track record on total-return and risk-adjusted bases.
- Regular rebalancing “back to a measure of relative value.”
The whitepaper concludes with a list of four outcomes investors can expect from WisdomTree’s smart-beta ETF products:
- Enhanced portfolio returns
- Reduced portfolio risk
- Increased dividend income
- More complete diversification benefits
The firm’s offerings include six U.S. dividend equity ETFs and four U.S. earnings equity ETFs.
For more information, download a pdf copy of the whitepaper.