Caution Handshade

Goldman Sachs Enters "Smart Beta" World: Proceed With Caution

Caution Handshade

There has been tremendous asset growth in exchange-traded funds (ETFs) over the last 5 years. According to the Investment Company Institute (ICI), net assets have grown from $777 billion at year-end 2009 to $1.974 trillion at year-end 2014 (250% total growth)[i]. Understandably, with the growth in demand for ETFs comes the growth in the number of investment products. The ICI reports the number of ETFs offered during the same time have almost doubled (1,411 as of the end of 2014).

Alongside the growth in the ETF market has been the growth in factor-based investing, or more popularly known as “Smart Beta.” “Smart Beta,” is a rules-based investment strategy that seeks to gain exposure to known systematic investment factors or perceived market inefficiencies in a transparent way. Some of the known factors that have systematically rewarded investors over long time horizons are size, value, and profitability.

Many fund companies like WisdomTree and Research Affiliates (RAFI) have been offering ETF solutions with factor-based investment styles for some time, and Goldman Sachs has recently decided to join the party. According to an article published in Investment News, Goldman Sachs launched its first series of low-cost ETFs based on its said methodology of selecting, “undervalued companies with upward price momentum, sustainable profits and less exposure to violent price swings.” The Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) can now be attained by investors for a low price of 0.09% per year. This is a substantially lower cost than offerings from Vanguard, iShares, and WisdomTree, and much lower than the 0.49% average expense ratio of “strategic beta” funds as reported by Morningstar Inc.

Although it sounds like a compelling proposition for investors to take advantage of, we suggest proceeding with caution. While companies like Morningstar may lump together all funds based of “smart beta” into one group, implementation of such a strategy is not universal. RAFI builds their U.S. large cap portfolio based off of fundamentals such as cash flow, dividends, sales, and book value, while also breaking the link between overall value and price. Goldman Sachs on the other hand is also incorporating elements of momentum and low volatility. These two funds could have substantially different performance figures based on the factors they are targeting.

While factor-based investing may seem like a recent phenomenon, the idea has been around since the 1970s and has been implemented in actual investment strategies since the early 1980s by fund companies like Dimensional Fund Advisors (DFA). When vetting a particular factor-based investment strategy it is important to understand what in fact the manager is actually trying to accomplish and conduct proper due diligence on the factors they are trying to capture. For example, in regards to trying to capture momentum or securities with low volatility, academic research is mixed in terms of the existence of such factors and furthermore, the ability to properly capture them in an investment strategy. We have written articles before on low volatility investment strategies as well as the momentum factor. In terms of basing an investment strategy off of fundamental indexing, we have written about some of the pitfalls of the theory, in general.

Proper due diligence does not end with academic support. We must also see if a manager has been able to effectively capture different factors in actual strategies. This is why partnering with an investment firm who has a long track record is very important. DFA has reliably delivered the factors they have sought to capture within their investment strategies. You can find comparisons against similar index providers in Step 11 of our 12-Step Recovery Program for Active Investors.

More importantly, beyond actual performance, is DFA’s unwavering belief in their investment strategy. The core of all of their investment strategies is time-tested, peer-reviewed, empirical research. If we were to ask Goldman Sachs what their investment philosophy is, we would expect you hear “whatever sells.”

We expect there to be continued growth in factor-based investing. It is important for investors to properly understand the factors that a particular strategy is trying to capture, understand the empirical evidence supporting each particular factor, and most importantly, find an investment manager who has a long enough track record of being able to effectively capture that particular factor in an actual investment strategy. Index Fund Advisors is committed to continually following this process so that our clients are receiving the most reliable investment advice.



[i] Investment Company Institute Factbook, 2015.