ETF smart-beta infighting misses the point

Earlier this month US smart-beta index provider Research Affiliates said smart-beta ETFs, which weight their stocks by factors other than market cap, were an overhyped segment of the market. The report accused 'smart' ETFs, such as those that focus on low volatility or value, of being driven almost entirely by inflated valuations and misplaced investor hype. "Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive," it said. Providers have not taken that accusation lying down.

ETF provider Wisdomtree has responded, arguing that its ETFs are not overvalued or successful due to artificially inflated stocks underpinning them. It says that its own indices take into account measures of valuation other than share price alone, and it also argues that its own dividend and income-weighted strategies are "conspicuous by their absence" in Research Affiliates' criticism.

All this infighting to some extent misses the point. Smart ETFs are only 'smart' for certain periods of time and should be seen as an investing style rather than a do-it-all market solution. Just as an open-ended fund manager could shoot the lights out when his particular style is in favour and fall behind in other markets, so certain smart-beta strategies will succeed in some markets and fall in others.

Research Affiliates is right in that performance-chasing, or pouring money into strategies on the basis of previous success, is a bad idea and something to avoid, although in the case of a momentum strategy that is entirely the investment case. But is it fair to say that the success of smart beta is due to performance-chasing alone? Probably not. There is no one list of 'smart-beta stocks' that all smart-beta cash has flowed into. In fact, Wisdomtree's retorts, which include complex explanations of its stock weighting process and rebalancing methodology, demonstrate the fact that few smart-beta products are alike.

That in itself is an issue. And there is no doubt that Research Affiliates is correct in questioning the validity of some of the more complicated and nuanced smart-beta indices that crunch together 10 different metrics to come out with a glossy brochure proclaiming the genius of that provider's market-defying ETF.

But sensible investors should be able to see through this marketing spin. The rules of investing remain the same - whatever fund vehicle you use. Base your investment choices on the market, style or region you expect to outperform going forwards, not on what has done well recently. In fact, if a strategy such as value investing or a focus on growth stocks has done well in recent years it could well be time to move away. And if a strategy is so complicated you don't understand it, do not invest.

This is not to say there is nothing to be worried about in the world of smart-beta investing. The blossoming world of highly niche ETF products with short track records and persuasive back-tested data will surely trip up some investors. And wider equity and bond markets are likely to only be more affected in future by the massive flows into ETFs. But that is likely to be an issue facing the most plain vanilla index trackers rather than the more convoluted solutions.

In the meantime, the ETF industry's internal squabbling about monikers and strategies does no investor any favours. Smart beta? Alternative beta? Factor investing? It's hard to imagine any investor caring half as much as the ETF providers bickering over the terms of use.

So amid the squabbling, keep your head and remember why you invest in the first place.