Q&A: Investors using index funds to try to beat the market

AP News
Posted: Feb 04, 2016 3:33 PM
Q&A: Investors using index funds to try to beat the market

NEW YORK (AP) — Don't try to beat the market.

The adage got pounded for years into investors, and many began to live by it. After seeing so many investments fail to keep up with the Standard & Poor's 500 index, investors put their money instead into low-cost index funds. They were happy to get returns that were the same as the market.

Now, though, a growing number of funds are pitching themselves as ways to get better — or more stable — returns than the market. But instead of hiring stock pickers to get there, these mutual funds and exchange-traded funds track different kinds of indexes.

Many are super-specialized. Some focus only on high-quality companies with stable earnings. Others hold only stocks that have had smaller price swings than the rest of the market. Some hold equal amounts of all the stocks in the S&P 500 index.

They stand in contrast to the S&P 500 index, which gives the most weight to the most valuable companies, a strategy known as "cap-weighting."

The industry calls these funds "smart-beta" options. It's a play on the financial term "beta," which measures how volatile an investment is compared with the market.

Martin Small, U.S. head of the largest ETF provider, iShares, recently talked about the big growth for this breed of funds. Answers have been edited for clarity.

Q: How much interest is there for these new types of funds?

A: You can see it in the flows. In 2015, we had roughly $21 billion into "smart-beta" ETFs (across the industry). Call that about 9 cents or 10 cents on the dollar that went into smart beta.

Q: What do you make of the term "smart beta?"

A: We don't like the term. "Smart beta" implies that cap-weighting is dumb or bad, and that is totally not true. All one has to do is look at the returns going back to the '40s of cap-weighted indices, and they have done pretty darn well.

If you had just owned the U.S. stock market or international developed-market equities for 20, 30, 40 years, you would have done fine with a cap-weighted approach.

I think the industry generally doesn't like the term, but no one has, as of yet, come up with another term that has seized the popular consciousness.

Q: So why do anything other than traditional index funds?

A: With more technology, more data, more understanding of markets, we can do more. Some people want something other than the cap-weighted return. They want an outcome, like some people want market exposure but lower risk. Other people want to outperform the market.

If your desire is to do one of those two things, then using a cap-weighted strategy doesn't meet your goal.

Q: So are investors usually in one camp or the other? Either vanilla index ETF or a smart-beta option?

A: More often, what I see now is that people are blending them. So someone takes money out of our S&P 500 fund, IVV, and adds it to LRGF, which is our multi-factor smart beta fund (It invests in an index that emphasizes certain slices of the market, based on quality, size and other factors). They might split it 50/50.

Other investors who have less of a risk appetite, they look at these minimum-volatility strategies. That was a huge category for us last year, and $10 billion flowed into those funds (across the industry).

Those funds are designed to perform in a way that smooths out the ride, so that when markets go soaring way high, they get most of that return, but when markets go way low, they capture less of that downside. These things now have track records.

Q: Is there a minimum age that a fund has to be, before people are willing to consider it?

A: It's highly dependent. In general, after one or three years, you see people believe more than they did in the beginning. But there are also ways to back-test it.

Q: So people believe in these low-volatility funds?

A: People are using minimum-volatility funds as their core, as a better way to do cap-weighting indexing, particularly if what you anticipate is more volatility.

I've watched them leg into it, but there are many early signs that investors are holistically replacing their S&P 500 investing with something like USMV because everyone is telling them there is going to be more volatility.

Q: Is it mostly older investors who are closer to retirement who are most interested?

A: We've seen a really big mix. Millennials, those who were skeptical of stocks in general, look at these as a better way of doing indexing, like this is just the next generation of indexing.