Estimated reading time: 3 minutes, 26 seconds

Smart beta funds are one of the hottest trends on Wall Street and are generating increased media attention.

At the same time, big firms including JPMorgan are aggressively promoting the products. The firm recently launched its JPMorgan Diversified Return Global Equity Fund, which is an exchange traded fund based on a smart beta strategy.

The firm is not alone in pitching smart beta as Morningstar data shows that there are currently some 367 such funds and that the products captured 31% of all money that flowed into ETFs in 2013, according to CNN.

As of May, the funds held some $367 billion in assets. With growing interest in smart beta products among investors, advisors would be well served to understand the advantages and disadvantages of the products.

Beta refers to pricing sensitivity of a stock relative to an index. For example, a beta of 1.2 implies that that a stock’s price movement will exceed that of the market by 20%. Smart beta products seek to generate excess beta by tracking indexes that are frequently rebalanced based on specified stock characteristics, such as dividends or valuations.

Proponents of the products maintain that rebalancing portfolios based on certain criteria can result in market outperformance over the long haul. In one sense it’s as simple as selling off stocks that have recently generated strong performance that may not be sustainable and buying stocks that have recently been beaten down by investors and may therefore have more attractive valuations.

While the increased trading volume of the funds results in the products having higher expense ratios than traditional index products, fees are generally lower than actively managed strategies.

The underlying indexes for many of the products seek to address investors’ concerns of traditional indexes that use market capitalization to determine the weighting of index constituents. Generally speaking, market capitalization indexes can be dominated by a small number of the largest companies found within the benchmarks. Smart beta funds also offer the advantage of potential market outperformance and because the products are based on indexes, they are more transparent than actively managed portfolios.

Critics of smart beta, express a variety of concerns over the products. One concern is that investors may have unreasonable expectations for the products to repeatedly outperform broader indexes and may panic sell when their smart beta portfolios trail the market.

Critics maintain that consistent outperformance by the products is unlikely and point to certain market conditions in which certain smart beta products are likely to underperform.

During certain market rallies, for example, momentum stocks outperform. In such environments, certain stocks generate attractive performance that causes additional investors to purchase the securities, which supports additional gains. The pattern continues to repeat and results in momentum stocks outperforming the broad market.

In such instances, valuations typically aren’t a good indicator of future performance because investors are attracted by recent performance results. Therefore, smart beta funds that sell off recent winners in favor of laggards may underperform.

Proponents of low-cost index funds, for their part, point to the higher fees of smart beta funds as a weakness of the products. They maintain that it can be difficult to generate sufficient excess returns to overcome the drag on performance of higher fees.

Bill Sharpe, the Nobel laureate and Stanford economist, is one of the more prominent critics of the products. He has said that, what appears to be empirical evidence, illustrates the performance of various smart beta strategies hasn’t been reproduced in other countries and that excess returns generated by the products declines over time.

For advisors, the goal is to manage clients’ expectations for the products—just like any other hot product that has come into the limelight over the years.

The bottom line is that successful investing requires a disciplined and long-term strategy, rather than big bets on the latest fads. That doesn’t mean, of course, that certain smart beta products may be without merit. Rather, it simply implies that advisors should approach the products with caution and stick with established asset allocation models when building their clients’ portfolios instead of hoping for the latest Wall Street product to generate outsized returns.

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