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Portfolio > Mutual Funds > Bond Funds

Smart Beta Gets Dumb

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For the record, I don’t believe in the existence of “smart” beta. The phrase is actually a cute invention coined by Wall Street marketers. Furthermore, the historical record does not support the claim that beta is always “smart.”

As proof, I examined three distinct segments of the bond market and discovered that allegedly “smart” beta can be dumb.

For example, the iShares iBoxx Corporate Investment Grade Bond Fund (LQD)—a bond ETF with an old school market cap weighting approach—has gained more than 17% over the past three years while its new-school alternative beta competitor the PowerShares Fundamental Investment Grade Bond Fund (PFIG) has delivered a subpar 5.38% return.

This sort of considerable underperformance in any market—especially the ungenerous bond market—isn’t a very smart result.

I also found significant underperformance by so-called “smart” beta ETFs in the high yield bond market.

Over the past three years, the SPDR Barclays High Yield Bond ETF (JNK) gained 22% while its peer rival the PowerShares Fundamental High Yield Bond ETF (PHB) has lagged by a disappointing 3%.

The persistence of lackluster performance among “smart” beta ETFs is also evident in the emerging market bonds.

The iShares JPMorgan USD Emerging Markets Bond Fund (EMB) has crushed the PowerShares Fundamental Emerging Markets Bond ETF (PFEM) by almost 16% over the past two years. Outperformance of this magnitude in the bond market—where long-term returns are typically smaller compared to stocks—is nothing to sneeze at.

What about the fact that old-school market cap weighted bond indexes assign bigger allocations to the largest issuers of debt? Isn’t that problematic? Even with this supposed shortcoming, old-school bond index ETFs are still effortlessly beating newer alternative beta bond ETFs.

In summary, you should be skeptical of anything bearing a “smart” beta label. Why? Because it doesn’t necessarily guarantee smart results.


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