A few years ago, the phrase “smart-beta ETFs” barely existed in the investing lexicon. Yet these exchange-traded funds are now the hottest category among fund sponsors, with nearly 400 of these funds now managing more than $150 billion in assets — with plans for many more to be launched in coming years.

#-ad_banner-#The key question: Are they worth it — or are they just a bad marketing concept in search of your funds? 

Smart betas were launched to address a clear problem that emerged in the fund community. Low-cost traditional ETFs were launched to provide investors with access to simple, passively managed portfolios that need not account for the salaries of million-dollar fund managers. 

Yet their “buy the whole group” approach to any theme, whether it was a particular industry, country or asset class, meant that each portfolio was packed with both good and bad investments. In defense of higher-priced mutual funds, at least fund managers took the time to weed out presumably bad investments and hold only good investments. 

The smart-beta ETFs aimed to be the best of both worlds: a higher degree of portfolio rebalancing to weed out the duds, in a fund that still was cheaper to buy than most mutual funds. (Many fund people will tell you that the term “passive/active” is a better description than the phrase “smart beta.” Other names for these funds include “strategic beta,” “factor-based” or “enhanced” ETFs.)

As a general rule of thumb, traditional ETFs have expense ratios from around 0.05% to around 0.80%. Smart-beta ETF expense ratios are generally between 0.50% and 1 % (though there are some that have much lower expense ratios), while most mutual funds have expense ratios (coupled with sales loads) that can move towards the 2% mark.

Before we answer the question of whether these funds are worth the higher price, let’s look at some types of smart-beta ETFs. That umbrella term includes:

• Contango/backwardation ETFs (those that focus on the rollover of short-term contracts)
• long-short spread funds
• technical analysis-focused funds 
• funds that focus on specific growth, valuation or momentum metrics (often referred to as “factor” funds)
• risk/volatility funds

Focusing on smart-beta ETFs that continually rebalance equity (stock) investments, the approach’s appeal is self-evident. As many leading gurus will tell you, it’s wise to trim your exposure to highly loved (and highly valued) stocks and and to shift your money toward less loved (and lower-valued stocks). In essence, that’s what many of these funds do for you. 

So are these funds worth it? Mutual fund managers, as you’d expect, are dubious. James Montier, who manages mutual funds at Boston-based GMO Asset Management, thinks that most of these smart-beta ETFs are unlikely to outperform traditional passive ETFs over the long haul. 

Rick Ferri, who manages client assets at low-cost index fund management firm Portfolio Solutions, is also predictably wary. “It all looks and sounds good on paper, but the guarantee is that it is going to cost you more money, you are going to take more risk, and you can underperform for a long time,” he recently told Bloomberg. 

Ferri added: “If all these people are outperforming the market, who is underperforming? There is no such thing as a free lunch. The product providers are selling the sizzle rather than the steak.”

Frankly, it’s hard to directly refute such claims. Indeed, the performance of smart-beta ETFs is impossible to calculate, simply because the category is so broad. For example, ETFs that expect to profit from high volatility were absolute duds last year, as I noted in a late 2013 review of ETFs.

The key is to understand the ETF’s approach and gauge its historical returns against a benchmark. As an example, we’ve been noting for several years that companies that aggressively buy back shares (often as part of a Total Yield strategy) outperform the broader market. So an ETF that focuses on buybacks should be worth its 0.70% expense ratio. Sure enough, the PowerShares Buyback Achievers ETF (NYSE: PKW), which I profiled last year, has outperformed the S&P 500 by roughly 50 percentage points over the past five years. 

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Emerging markets are also proving to be a fertile area for the smart beta approach. For example, the PowerShares FTSE RAFI Emerging Markets ETF (NYSE: PXH), which re-weights its portfolio to account for factors such as growth, price-book and dividends, has risen roughly 50% over the past five years, while the Vanguard FTSE Emerging Markets ETF (NYSE: VWO), a lower-cost passive counterpart, has risen roughly 30% in that time. 

To be sure, these are cherry-picked examples, and you should compare any smart-beta ETF you are researching against its own passive ETF counterpart. 

The good news: Many smart beta ETFs that were launched in 2010 and 2011 now have several years’ worth of performance data under the belt, so you can measure them against benchmarks if they can justify their expense ratios. 

Risk to Consider: The markets have generally moved upwards over the past five years, so it’s still unclear how smart-beta ETFs will perform in a bear market. It will be most interesting to see how they do in a flat market, when the active approach should theoretically yield gains.

Action to Take –>The rapidly rising appeal of smart beta ETFs means that fund sponsors will likely launch many more of them over the next few years. Some of them will simply replicate existing ETFs, and may not be worth the trouble. Fund sponsors will sometimes provide back-tested data when launching new ETFs, and you should read the prospectus to see how any new ETF would have conceivably performed in the past. 

The key takeaway: Smart-beta ETFs don’t charge obscene expense ratios. The cost to own them is often only slightly higher than a passive ETF, and even modest outperformance can justify the expense ratio differential.

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