Popular strategy forces investor discipline “Smart beta” may be the biggest phenomenon in exchange-traded funds. Assets in these portfolios, which track stock indexes but tweak the component weightings based on a formula that the managers expect to enhance long-term, risk-adjusted returns, totaled $441 billion on March 31, according to investment researcher Morningstar, or 26.6% of assets in all stock ETFs. Such popularity is bound to provoke praise and criticism from investment commentators. This column has featured one example of each over the last couple of years. The pro argument is that smart beta, also known as strategic beta, neutralizes an inherent flaw in conventional stock indexes: their capitalization-based weightings. Because the indexes and portfolios that track them have greater exposure to companies with higher market values, investors are liable to own too much of businesses that are big, and therefore less likely to grow fast, or else businesses that are just too expensive. The related con argument is that smart-beta funds get the right answer by accident. They have excelled because their deviations from unadulterated index funds have been in favor of certain segments of the market, such as smaller companies and value stocks, that have outperformed. When those segments fall from grace, the naysayers contend, the funds are likely to lose their advantage. Another case is being made against smart beta these days, and it doesn’t seem to be giving the funds a fair shake. An article in the April issue of Bloomberg Markets magazine suggests, through quotes of investment advisers and a tone that’s skeptical verging on cynical, that purveyors of smart-beta funds are pulling a fast one and providing a product to which there is less than meets the eye. “It’s index investing with key twists, all of them rules-based, with no active management required,” the authors, Anthony Effinger and Eric Balchunas, write, summing up the idea behind smart beta. The implication seems to be that managers aren’t earning their money, that instead of picking stocks, they’re programming a black box with a set of criteria to do it for them, then sitting back and watching the magic happen. The headline on the version of the piece that ran on the main Bloomberg website, “Funds Run by Robots Now Account for $400 Billion,” conjures an image of Rosie, the robot maid in “The Jetsons,” making portfolio choices. Some managers can be fairly accused of shirking their responsibility and taking shareholders’ money under false pretenses. They run mutual funds known as closet-index trackers because they are sold as actively managed products and set their management fees accordingly, yet their holdings deviate so little from benchmark indexes that their returns cannot keep pace with those of true index funds due to the cost discrepancy. Smart-beta funds are marketed as what they are: hybrid vehicles that track stock indexes with an element of active management embodied in the algorithms they use to adjust component weightings. That’s why the generic process used to create the funds is known by the oxymoronic term “fundamental indexing.” Unlike closet trackers, which charge for custom tailoring and provide off-the-rack results, smart-beta funds tend to have expenses that fall in between those of actively managed funds and index funds. Those expenses are bound to come down, too, as more management companies offer similar products. Some of them no doubt will try new stock-picking methodologies so that funds will compete intellectually as well as financially. The smart-beta concept is still new enough that prospective investors should heed the concerns of the critics. The outperformance of some funds may be an artifact of some other phenomenon in the markets than the ones claimed by their managers, limiting their ability to continue to thrive. Whether that’s true should become clear as new funds come on the market and existing ones develop longer track records. Even if that turns out to be the case, smart-beta funds will continue to have a feature that some critics consider a bug: the black-box program that forces managers to stick with a system. No chasing performance. No quarterly window dressing. No panicking at market bottoms. Rosie may turn out to be a better stock picker than her more highly compensated human counterparts. Conrad de Aenlle