The mainstream press is now latching on to smart-beta ETFs. As this column has repeatedly noted, the old four-sector model of index funds/ETFs has been surpassed by the sheer variety of relatively cheap ETFs on offer, covering vastly different sectors or investment methodologies, allowing for advisors to take views on the market in both the long and short term – and, most importantly, execute them cheaply.

Smart-beta funds can make the holy grail of alpha more accessible – or at least cheaper. Some mutual funds achieve it – mostly small cap funds, more particularly those that specialize in energy and/or materials or else microcap companies. It’s not that hard to beat an index fund if the active manager has the chops because these sectors are relatively illiquid, and thus hard for index funds to get into.

But smart beta involves something different than stock-picking skill. It involves filters that mimic what a rational investor would do: invest in the economic footprint of a company, for fundamental indexing,  select a sample of highly rated companies, as equal weighting often does, or choose a bundle of low-risk stocks, as low-volatility indexes do.

Herein lies the rub. Backtesting can show a 200 basis point advantage for a smart-beta index over a market-cap index. But that’s before fees and trading costs. If a smart-beta ETF comes in with an MER of 65 basis points, the investor has lost one-third of the alpha.

If that ETF comes with a trailing commission, half the expected alpha is gone. If that ETF is wrapped inside a mutual fund, the expected alpha is almost entirely swamped.

There may be good reasons for having a trailing commission on an ETF, or for putting it into a mutual fund structure. But when it comes to alpha, it becomes all the more important for advisors to separate the pure costs of investing from the cost of advice. Good advice can lead to better investment results, and it is worth paying for.

Scot Blythe is a Toronto-based financial writer.
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