Pouring Cold Water

Adam M. Grossman

SOMETIMES WE DON’T give kids enough credit. Last week, my first-grader reminded me of this fact. On a trip to CVS, he was looking through the drink cooler, when he asked, “What’s Smartwater?” Before I could answer, he started with his own commentary. Seeing the price tag—which was more than double that of the regular water next to it—he wondered, “Why’s it smart? It’s just water. Is it really going to make me smart?”

This made me realize something: As consumers, we’re pretty skilled when it comes to spotting inflated prices and exaggerated marketing claims. My son proved that we have these abilities by age seven, if not earlier. But when it comes to the investment world, unfortunately, it is not as easy to make these distinctions. I see at least two reasons for that.

First, there’s the sheer quantity of investments available. In the U.S., there are more than 8,000 mutual funds offered in more than 25,000 individual share classes. This makes it difficult to do effective comparison shopping.

Second, like the food industry, the mutual fund industry loves creating new products with magical sounding marketing messages. In fact, over the past few years, one of the fastest-growing trends is mutual funds carrying the “smart” label. But instead of smart water, these new funds supposedly offer smart beta.

What does that mean exactly? Forget the “smart” for a minute. “Beta” is a basic finance term that has been around for half a century. It refers to the way in which the price of an investment varies in relation to the movement of the overall market. Stocks with high betas bounce around more than average, while stocks with low betas are relatively steady. The promise of smart beta is that these investments will deliver higher returns for a given level of volatility—and potentially beat the overall market.

Here’s an example: Unlike the typical index fund, which holds stocks in proportion to their size, one popular smart beta strategy seeks to hold an equal amount of every stock. Other smart beta strategies seek to capitalize on stock price momentum, on the quality of companies’ financial results or on the level of their dividends.

Will these smart funds actually help you to earn more? In some cases, there is indeed a sound academic basis for the strategy, and it’s certainly possible that they’ll beat the overall market.

But here’s the thing: The only aspect of these funds that is actually new is the catchy marketing name—and higher price—that some vendors have attached to their funds, as they brand them “smart beta.” The reality is, these kinds of strategies have been around for decades. In fact, way back in 1981, long before the term was coined, an entire mutual fund company was founded on the basis of smart beta. The company had a much more mundane name for it, but it’s exactly the same thing. Indeed, some investment practitioners—those who took the time to understand the concepts involved—have always used them in building portfolios by, say, buying funds that focus on small-company stocks or bargain-priced value stocks.

Confucius supposedly said, “Life is really simple, but we insist on making it complicated.” It’s doubtful he really said this—but, if he did, he could have been referring to Wall Street. Smartwater claims to provide “purity you can taste, inspired by the clouds.” Perhaps that’s true, but that lofty promise comes at a price. Personally, I’d rather pay less and get a largely identical product, even if it carries a less trendy label.

Similarly, smart beta funds may sound new and smart. But in my opinion, when it comes to your investments, your smartest move is to keep it simple. Yes, the concepts underlying smart beta do have value. But you can attain those benefits without funds with faddish labels and inflated prices.

Adam M. Grossman’s previous articles include Tax Time Robbery, Six Figures, Tiny Taxes and Free for All. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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