Are Smart Beta ETFs Smart Investments?
Thursday, August 14, 2014

The concept of smart beta funds has intrigued me. Smart beta funds use quantitative rankings to determine what stocks to hold and how to weight them. I agree with the general concept, but I wondered if smart beta exchange-traded funds (ETFs) actually delivered better performance. So I used the data in our ETF Guide to conduct an analysis.

This would seem to be an easy task: just line up the funds and compare the returns. After all, most funds, be they mutual funds or ETFs, can be quickly categorized as passive or active, small cap or large cap, domestic or international, etc. With smart beta ETFs, things weren’t so simple. In fact, I quickly found myself facing a quandary: What actually counts as a smart beta fund?

Morningstar does not designate funds as being smart beta in the data it supplies. (We use Morningstar’s data for our mutual fund guide, our ETF guide and our Quarterly Mutual Fund Update.) A search on Google for a list of smart beta ETFs didn’t turn up much either. This meant my first step was to create a list of smart beta ETFs.

The first few choices were easy. I knew there are ETFs based on Research Affiliates smart beta indexes, such as the PowerShares FTSE RAFI US 1000 (PRF). I included ETFs based on equal-weight market capitalization indexes, such as Guggenheim S&P 500 Equal Weight (RSP), even though equal-weight indexes were in existence before the term “smart beta” became popular.

The next questions were harder to answer: What actually counts as a smart beta ETF? Does momentum count? How about low volatility? What about dividends? And if a fund doesn’t have a name clearly suggesting that an alternative ranking system is used, how does one know whether or not it is a smart beta fund? Not to mention the simple question of when an index is merely a non-traditional index as opposed to being a smart beta index.

I’d love to give you a simple explanation of what specifically counts as being smart beta, but I don’t think one exists. Rather, personal judgment plays a big role. Even if one were to look at the indexes tracked by every equity-focused ETF—a very time-consuming task—a decision about what to include and what to exclude would still need to be made. Given that, I searched the list of domestic ETFs for names implying some type of fundamental weighting, equal capitalization weighting, and high or low volatility. I then scanned through the list, looking for ETFs I either knew to be marketed as smart beta funds (e.g., WisdomTree SmallCap Dividend (DES)) or funds that sounded like they could be smart beta funds. For the latter, I went to their fund families’ website to investigate and make a judgment call.

In total, I identified 59 domestic smart beta funds. Slightly more than half of them (29) were launched after January 2011. In contrast, only 27 have five full years of return data. Given the large number of domestic ETFs without several years of return data, the jury is still out as to whether smart beta ETFs, in aggregate, are smart investments. I simply don’t have enough information on enough funds to form a definitive opinion.

This is not to say all smart beta funds should be avoided until more data is available. There are five domestic smart beta ETFs with encouraging long-term performance: Guggenheim S&P 500 Equal Weight (RSP) and PowerShares FTSE RAFI US 1000 (PRF) in large-cap, WisdomTree MidCap Earnings (EZM) in mid-cap, and RevenueShares Small Cap (RWJ) and WisdomTree SmallCap Dividend (DES) in small-cap. These funds beat than their category averages on a fairly (but not completely) consistent basis over the past five years. WisdomTree’s Dividend Ex-Financials (DTN) and MidCap Dividend (DON) ETFs also outperformed their respective large-cap and mid-cap ETF category averages over the last five years, but with less consistency. All of these funds also performed better than the comparable iShares market-weighted ETFs for each respective category, a positive sign since the iShares funds (and similar offerings from SPDR and Vanguard) are among the lowest cost offerings.

Below is the list of smart beta ETFs I created. It’s pretty comprehensive, though I’ll stop short of calling it a complete list. Given the level of subjectivity over what is and what is not a smart beta fund, arguments could be made what should be added to the list and what should be excluded from it.

Table 1. A List of Domestic Smart Beta ETFs


ETF Name (Ticker)
NAV Ret YTD 2014 (%)
NAV Ret 2013 (%)
NAV Ret 3 Year Ann'l (%)
NAV Ret 5 Year Ann'l (%)
Total Assets ($ Mil)
Expense Ratio (%)
 Large-Cap Stock Category Average
6.8
32.1
16.1
19.1
4,035
0.40
Direxion NASDAQ-100 Equal Wtd Idx Shrs (QQQE)
8.1
40.2
15
0.35
First Trust NASDAQ-100 Equal Weight Idx (QQEW)
8.0
40.0
16.2
21.4
423
0.60
First Trust Value Line Dividend Index (FVD)
8.5
26.6
15.5
18.5
896
0.70
First Trust Value Line Equity Allc Index (FVI)
5.0
34.7
10.8
16.3
5
0.70
FlexShares Quality Dividend (QDF)
7.0
35.7
505
0.38
FlexShares Quality Dividend (QDF)
7.0
35.7
505
0.38
FlexShares Quality Dividend Defensive (QDEF)
6.8
32.3
61
0.37
FlexShares Quality Dividend Defensive (QDEF)
6.8
32.3
61
0.37
FlexShares Quality Dividend Dynamic (QDYN)
7.7
36.0
64
0.38
FlexShares Quality Dividend Dynamic (QDYN)
7.7
36.0
64
0.38
Guggenheim S&P 500 Equal Weight (RSP)
8.4
35.6
16.7
21.8
8,164
0.40
iShares MSCI USA Minimum Volatility (USMV)
6.0
25.1
2,640
0.15
iShares MSCI USA Momentum Factor (MTUM)
5.9
304
0.15
iShares MSCI USA Quality Factor (QUAL)
3.7
430
0.15
iShares MSCI USA Size Factor (SIZE)
8.4
133
0.15
iShares MSCI USA Value Factor (VLUE)
7.1
155
0.15
PowerShares FTSE RAFI US 1000 (PRF)
7.5
35.1
17.0
21.0
3,594
0.39
PowerShares Fundamental Pure Large Core (PXLC)
7.8
35.6
17.4
18.2
42
0.39
PowerShares Fundamental Pure Large Grow (PXLG)
10.0
29.4
17.0
114
0.39
PowerShares Fundamental Pure Large Value (PXLV)
5.6
33.0
16.1
34
0.39
PowerShares S&P 500 High Div Portfolio (SPHD)
12.9
20.9
183
0.30
PowerShares S&P 500 High Quality (SPHQ)
5.9
32.0
16.3
18.8
385
0.29
PowerShares S&P 500 High Quality (SPHQ)
5.9
32.0
16.3
18.8
385
0.29
PowerShares S&P 500 Low Volatility (SPLV)
8.5
23.3
15.8
4,161
0.25
PowerShares S&P 500 Low Volatility (SPLV)
8.5
23.3
15.8
4,161
0.25
Schwab Fundamental US Broad Market ETF (FNDB)
7.1
87
0.32
Schwab Fundamental US Large Company ETF (FNDX)
7.1
129
0.32
SPDR Russell 1000 Low Volatility ETF (LGLV)
7.8
11
0.20
SPDR S&P 1500 Momentum Tilt ETF (MMTM)
6.4
33.2
13
0.35
WisdomTree Dividend ex-Financials (DTN)
9.0
27.6
16.9
21.8
1,210
0.38
WisdomTree Earnings 500 (EPS)
6.7
32.6
16.7
18.6
109
0.28
WisdomTree Equity Income (DHS)
9.3
24.4
16.8
20.9
893
0.38
WisdomTree LargeCap Dividend (DLN)
7.6
27.4
16.2
18.9
1,844
0.28
WisdomTree LargeCap Value (EZY)
7.0
30.7
14.8
17.7
28
0.38
WisdomTree Total Dividend (DTD)
7.8
28.0
16.3
19.5
461
0.28
WisdomTree Total Earnings (EXT)
6.6
33.7
16.8
19.3
81
0.28
WisdomTree US Dividend Growth (DGRW)
5.1
119
0.28
 
Mid-Cap Stock Category Average
7.5
36.0
15.5
21.6
1,920
0.40
FlexShares Mstar US Mkt Factors Tilt ETF (TILT)
6.0
35.8
694
0.27
Guggenheim Russell 1000 Equal Weight (EWRI)
9.7
34.6
16.3
117
0.40
Guggenheim Russell MidCap Equal Weight (EWRM)
10.0
35.1
16.3
143
0.41
PowerShares Fundamental Pure Mid Core (PXMC)
8.0
33.4
14.5
19.2
33
0.39
PowerShares Fundamental Pure Mid Growth (PXMG)
6.6
27.3
11.6
17.6
94
0.39
PowerShares Fundamental Pure Mid Value (PXMV)
10.4
40.6
19.2
20.9
48
0.39
PowerShares S&P MidCap Low Volatility (XMLV)
11.1
31
0.25
PowerShares S&P MidCap Low Volatility (XMLV)
11.1
31
0.25
WisdomTree MidCap Dividend (DON)
10.7
33.0
17.8
24.3
1,151
0.38
WisdomTree MidCap Earnings (EZM)
7.5
40.2
18.0
24.4
583
0.38
 
Small-Cap Stock Category Average
3.6
39.7
15.8
21.7
1,818
0.30
Guggenheim Russell 2000 Equal Weight (EWRS)
3.3
40.5
13.5
42
0.45
PowerShares FTSE RAFI US 1500 Small-Mid (PRFZ)
3.7
41.8
15.7
23.3
1,004
0.39
PowerShares Fundamental Pure Small Core (PXSC)
4.6
35.5
14.1
18.6
15
0.39
PowerShares Fundamental Pure Small Grow (PXSG)
6.3
32.3
12.3
18.4
31
0.41
PowerShares Fundamental Pure Small Value (PXSV)
4.4
44.1
18.2
21.4
69
0.39
PowerShares S&P SmallCap Low Volatility (XSLV)
4.1
56
0.34
RevenueShares Small Cap (RWJ)
4.5
45.5
19.0
23.9
293
0.54
Schwab Fundamental US Small Company ETF (FNDA)
6.2
90
0.32
SPDR Russell 2000 Low Volatility ETF (SMLV)
5.4
15
0.25
WisdomTree SmallCap Dividend (DES)
4.5
36.9
17.5
22.5
1,085
0.38
WisdomTree SmallCap Earnings (EES)
1.7
45.4
16.6
22.5
463
0.38
WisdomTree US SmallCap Dividend Growth (DGRS)
1.4
26
0.38

Copyright 2014 American Association of Individual Investors and Morningstar, Inc. All Rights Reserved.

More on AAII.com

The Week Ahead

Dow component The Home Depot (HD) will report earnings Tuesday. Joining it will be 10 other members of the S&P 500, including Medtronic (MDT) and The TJX Companies (TJX) on Tuesday and Hewlett-Packard (HPQ), Lowe’s Companies (LOW) and Target (TGT) on Wednesday.

The week’s first economic report will be the National Association of Home Builders housing market index, released on Monday. Tuesday will feature the July Consumer Price Index (CPI) and July housing starts and building permits. The minutes from the August Federal Open Market Committee meeting will be released on Wednesday afternoon. Thursday will feature the August Philadelphia Fed survey, July existing home sales and the August PMI Manufacturing Flash.

The Treasury Department will auction $16 billion of inflation-adjusted securities (TIPS) on Thursday.

The Social Security Administration will be holding its inaugural National my Social Security Week to promote having a my Social Security  account. A my Social Security account can be used for getting verification letters, managing your benefits and checking your Social Security statement.

What’s Trending on AAII
  1. Common Investor Mistakes and Other Investing Insights

  2. Real Returns Favor Holding Stocks

  3. Model Fund Portfolio: Adjust Risk Based on Personal Factors

AAII Sentiment Survey

Optimism surged and pessimism plunged in the latest AAII Sentiment Survey. This is a shift in attitudes about the short-term direction of stock prices, as optimism experienced its biggest one-week gain in six months and pessimism experienced its largest two-week fluctuation in nearly a year.

Bullish sentiment, expectations that stock prices will rise over the next six months, surged 8.9 percentage points to 39.8%. This is the biggest one-week rise in optimism since February 13, 2014, when it jumped 12.3 percentage points to 40.2%. Bullish sentiment is now at its highest level since June 12, 2014 (44.7%). This week is also just the third in the past 22 weeks with optimism above its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose by 2.3 percentage points to 33.2%. The rebound keeps neutral sentiment above its historical average of 30.5% for the 32nd consecutive week. This is the third-longest streak of consecutive weekly readings above 30.5% in the survey’s history.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 11.3 points to 27.0%. The drop puts pessimism at a six-week low. It also puts bearish sentiment below its historical average of 30.5% for the 37th time in the past 44 weeks.

This week's 11.2 percentage point drop in bearish sentiment follows last week's 7.1 percentage point rise. A fluctuation of comparable size has not occurred since August 2013. Pessimism jumped 14.7 percentage points to 42.9% on August 22, 2013, and then pulled back by 12.1 percentage points to 30.7% on August 29, 2013.

The big change in sentiment this week occurred as both large-cap and small-cap stocks rebounded from their recent lows. Changes in the composition of AAII members taking the survey this week relative to last week may have also had an effect. (We send out reminders to take the survey to a rotating group of AAII members each week.) Other factors include second-quarter earnings, sustained economic growth and the Federal Reserve’s tapering of bond purchases. Keeping some individual investors pessimistic are prevailing valuations, the failure of the S&P 500 to set new highs, events in the Middle East and Ukraine, the pace of economic growth and Washington politics.

It should be noted that despite this week’s big changes, both optimism and pessimism remain well within their respective typical ranges. Neither is unusually high or low at current levels.

This week’s special question asked AAII members for their opinion about whether U.S. corporations should pursue tax inversions. Approximately 49% of respondents said companies should pursue inversions, while 36% said companies should not. Nearly one in four of those who are in favor of inversions thought such transactions could pressure Congress to reform the tax code. A nearly equal proportion of those not favoring inversions said the tax law needs to be changed. Several members, both for and against inversions, described the U.S. corporate tax rate as being both high and a reason why inversions are being pursued.

Here is a sampling of the responses:

  • “U.S. corporations should do what’s best for shareholders. The U.S. needs to fix/simplify its tax code.”
  • “If a corporation primarily receives its income in the U.S., it should pay its taxes in the U.S.”
  • “Corporations should pursue inversions until the U.S. modifies and reduces its uncompetitive tax rate.”
  • “I believe this tax loophole should be removed. It perverts our economic system.”
  • “While patriotic concerns are debatable, any corporation may adhere to the law of the land.”
  • “Yes, corporations have a fiduciary duty to do so. It’s not their problem that Congress is so dysfunctional.”


This week’s Sentiment Survey results:

Bullish: 39.8%, up 8.9 points
Neutral: 33.2%, up 2.3 points
Bearish: 27%, down 11.3 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!