Someone asked me about Smart Beta in the forum the other day and I got to thinking about this. Indexers are all basically chasing some form of beta. But some indexers chase beta in stupid ways and some indexers chase beta in smart ways. An increasingly common example of this is the many forms of factor investing that have become popular in recent years (in case you haven’t noticed, I don’t like factor investing – see here, here, here and here). I am generalizing, but I tend to believe that factor investing is just a new clever way to get people to pay higher fees for owning index funds. Now, this particular reader asked about the profit factor so I went exploring.
It turns out that there are more than a few ETFs that track this profit factor. The largest one is a WisdomTree fund (ticker: EZM) that has 770 million in assets and “seeks to track the investment results of earnings-generating mid-cap companies in the U.S. equity market.” So, I go and compare this fund to the Russell Mid-Cap Index. It actually appears to be beating the index since inception, but it has a 99% correlation. Something doesn’t smell right about that. So, I look under the hood and find that it actually deviates from the Mid-Cap Index quite a bit. While the Mid-Cap Index has an average market cap of 10.5B this fund has a market cap of just 4.2B. Ah, so there’s the outperformance. It’s not profits, it’s just higher risk smaller cap stocks. And if you layer on the Russell 2,000 Small Cap Index, whose market cap is 1.5B, you get a near perfect replica of EZM. This is precisely what I expected given that I’ve run some version of this experiment almost every day for the last few years when assessing people’s portfolios.
The kicker is, this fund isn’t “smart” at all. The only thing that’s smart about it is that it deviates from the Russell Mid-Cap Index giving it the appearance of better performance. And so what we have here is a sort of sad case of dumb money chasing market inefficiency and proving that the only thing inefficient here is their factor chasing charade. And in doing so they’re paying 0.38% per year for a fund that costs as low as 0.07% elsewhere. That’s almost $2.5 million in annual fees being flushed down the drain there. And that’s just one fund out of a growing list of hundreds and maybe thousands. I’d laugh if it didn’t make me sad.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.