A new group of funds that claim to outperform the broad market while taking less risk are worth exploring—if you're willing to look under the hood.
Ever since the dot-com crash more than a decade ago, Wall Street and the mutual fund industry have been on a relentless push to plug what they are now calling “smart” beta strategies. These funds promise reasonable returns with lower risk through a variety of techniques.
But pursuing a smart-beta strategy isn’t as simple as just buying a fund with that name and thinking it will outperform conventional index funds. There’s always a trade-off in costs, risk and return, so you need to dig much deeper to get beyond simplistic marketing pitches.
For example, let’s say you were seeking an alternative strategy to traditional S&P 500 index funds that weight the holdings in their portfolios by market valuation.
In such traditional “cap-weighted” S&P 500 funds, the top holdings would be Apple APPLE INC. AAPL 0.6393% at about 3% of the portfolio, followed by ExxonMobil EXXONMOBIL CORP. XOM -0.4024% at 2.6% and Microsoft MICROSOFT CORP. MSFT -0.1723% at just under 2%. Every other stock in the portfolio would represent a slightly lower percentage of the total holdings.
The idea behind cap-weighting is that the biggest U.S. stocks by popularity ought to represent the largest portions of a broad-market portfolio. This is what economist John Maynard Keynes called a “beauty contest,” with investors bidding up the prices of the most glamorous stocks. The downside is that these companies may be overpriced and may not have as much room to grow as other, bargain-priced stocks.
One alternative in the smart beta fund category is a so-called equal-weighted stock index fund such as the Guggenheim S&P 500 Equal-weight ETF RYDEX ETF TR GUGGENHEM S&P500 EQUAL WEIG RSP -0.4597% , which holds the same stocks as the S&P Index, only in equal proportions. This design somewhat side-steps the overpricing issue because it’s less exposed to beauty contestants, especially when they falter a bit.
To date, both the long- and short-term performance of the equal-weighted strategy has been better than cap-weighted index funds. The Guggenheim fund has beaten the S&P 500 index over the past three, five and 10 years. With an annualized return of 9.7% over the past decade through June 6, it’s topped the S&P index by more than two percentage points over that period. But it costs 0.40% in annual expenses, compared with 0.09% for the SPDR S&P 500 Index ETF.
Once you start to ignore the beauty pageant for stocks, is there an even “smarter beta” strategy?
What if you picked the best stocks based on a combination of value, sales, cash flow and dividends? You might find even more bargains in this pool of companies. They’d have strong fundamentals and might be more consistently profitable over time.
One leading “fundamentally weighted” portfolio, which also resides under the smart beta umbrella, is the PowerShares FTSE RAFI US 1000 ETF POWERSHARES EXCHAN FTSE RAFI US 1000 PORTFOLIO PRF -0.3514% , which also has outperformed the S&P 500 by about two percentage points over the past five years with an annualized return of 20 percent through June 6. It costs 0.39% annually for management expenses.
The PowerShares fund owns some of the most-popular S&P Index stocks like Exxon Mobil, Chevron CHEVRON CORP. CVX -1.0203% and AT&T AT&T INC. T 0.0284% , only in much different proportions relative to the cap-weighted indexes. The RAFI approach focuses more on cash, dividends and finding undervalued companies, so it’s not necessarily looking for the most-popular stocks.
Although looking at the rear-view mirror for index-beating returns seems to make equal- and fundamental-weighted strategies appear promising long term, you also have to look at internal expenses to see which strategy might have the edge.
Turnover, or the percentage of the portfolio that’s bought and sold in a year, is worth gauging in both funds. Generally, the higher the turnover, the more costly the fund is to run. That eats into your total return. The PowerShares fund has the advantage here with an annual turnover of 13%, compared to 37% for the Guggenheim fund.
Over the long term, “fundamentally weighted smart beta strategies are likely to outperform the equal weighted approach,” note Engin Kose and Max Moroz with Research Affiliates, a financial research company based in Newport Beach, California, which largely developed the concept of fundamental weighting and is behind RAFI-named indexes.
But just considering costs doesn’t end the debate on equal- and fundamentally weighted funds. While they may be higher-performing than most U.S. stock index funds over time, they are not immune from downturns. Both lost more than the S&P 500 in 2008 and 2011.
While it may be difficult to predict how these funds will perform in a flat economy or a sell-off, they are worth considering to replace your core stock holdings, and may be the wisest choices among the smarter strategies.
Mutual funds that mimic hedge funds are Wall Street's hot new thing. Too bad they hedge away your best shot at returns.
So-called liquid alternative funds are the latest product Wall Street is pushing on retail investors. In 2013, about $40 billion of new investments flowed into the funds, up from $13 billion the previous year. The funds employ the kinds of strategies used by hedge funds, the less-regulated portfolios reserved for institutions and high-net worth investors. For example, in addition to owning investments outright, they’ll go “short”—that is, bet on stocks or market indexes to go down.
Hedge funds have benefited from the mystique of exclusivity, and for a while boasted pretty great returns. Lately, though, their returns aren’t all that impressive compared with what you can make just owning an S&P 500 index fund.
And mutual funds that mimic these strategies haven’t exactly shot the lights out either. For instance, the average market neutral fund, which seeks to deliver gains in both good and lousy markets, has returned only around 2% a year over the past five years, according to Morningstar. That’s about a tenth of the gains of the broad market during that time.
Financial sophisticates will call that an unfair comparison. Fine. But there’s a reason besides performance to give clever-sounding hedge-like strategies a pass.
Consider this deal: I’ll sell you this very nice antique vase. And I’ll let you in on a secret, too. A magic fairy lives inside the vase, and will grant the owner a wish.
You do not really believe in magic fairies. But you might still buy the vase at the right price, because, hey, it’s a nice vase. And if there’s a chance about the fairy…
When you buy a regular stock fund, you’re buying the vase. Most of what you get is the market’s return. When the market goes up, most funds make money. And when the market goes down, most funds go down. Managers try to add a bit of performance on top, by making smarter picks than the competition. But for the most part, if you know how the S&P 500 did this year, you can make a pretty good guess about how your fund did. Even if your manager isn’t all that skilled, you can still do okay so long as the market rises.
Buying a hedge fund, on the other hand, is like paying for the magic fairy without getting the vase.
The classic hedge strategy tries to eliminate or reduce the market factor. There are lots of ways to do this, including chasing illiquid assets or hopping among wildly different asset classes. In a long-short or market-neutral strategy, a manager might look at Apple and Microsoft and decide that Apple is a relatively better investment than Microsoft. By buying Apple and “shorting” Microsoft, the manager can in theory make money in both rising and falling markets, as long as Apple falls less than Microsoft in a down market, and rises more than Microsoft in an up market. (Many hedge strategies are head-spinningly more complex than this, but this captures the rough idea.) Investing in a hedge fund might reduce your market risk, but in return it bets more heavily on the manager’s investment-picking skill.
Skilled managers aren’t as elusive as magical fairies, but for practical purposes they may as well be. After fees, the vast majority of regular mutual funds don’t beat their benchmark indexes. The reason is simple: Almost by definition, the average money manager must deliver the market’s average, minus fees. Though some managers do outperform over time, it’s hard to tell which ones were lucky and which ones have a skill that will persist over time.
It might be that managers of real hedge funds, who have some control over when money comes into and out of their funds, can use the extra flexibility they have to find an edge. But it is doubtful that in the world of mutual funds, which must be able to hand investors their cash back on any given day, that there is a special secret pool of skilled managers who only work for funds where shorting and leverage and other exotic tactics are allowed.