With the ever increasing popularity of ETFs it is not surprise that we are starting to see a whole new class of index products that are differentiated from the basic indexes that we are all used to, like the S&P 500. Traditionally indices have been market cap weighted, meaning larger companies will have a larger allocation in the index. I am sure there is a reason that indices started as market cap weighted, I just don’t know what it is. There is no rule that this is a better way, it just is what it is. Now we are starting to see more and more “smart beta” products. These ETFs slice and dice indices in a bunch of different ways, for example some equally weight all stocks in the index, others focus on low beta stocks, others focus on high beta stocks. All will claim that their way is better than the standard market cap weighted index. Maybe they are but a few things you need to be aware of in evaluating these products:
1. Wall Street lives on continual money in motion and continual selling of new products. Once something becomes commoditized, like market cap weighted index funds (we don’t need another S&P 500 ETF or another Russel 200 ETF for example) then Wall Street will come out with a new twist, not always based on what is better, but based on what it can sell.
2. We have tons of history through different market cycles on market cap weighted indices, we don’t have it on smart beta. Most of these products are developed through backtesting, which there is nothing wrong with, but done the wrong way can result in curve fitting (basically blindly finding something that beat market cap indices in the past and just assuming it will in the future).
We use some of these products and will continue to evaluate others so I do believe that they add some value to the current investment landscape, but just like with everything Wall Street comes out with investors need to tread with caution and do their homework.