Smart Beta ETFs

In recent years, Smart Beta exchange-traded funds (ETFs) have become increasingly popular among investors seeking to achieve better risk-adjusted returns. These ETFs use a rules-based approach to select stocks, with the goal of outperforming traditional market cap-weighted indexes. In this article, Benzinga explores what Smart Beta ETFs are, how they work and the pros and cons of investing in them.

What are Smart Beta ETFs?

Smart Beta ETFs use a rules-based approach to selecting stocks. Unlike traditional market-cap weighted ETFs, Smart Beta ETFs use factors such as value, quality, momentum and low volatility to determine which stocks to include in the ETF. The goal is to achieve better risk-adjusted returns than traditional market-cap-weighted ETFs.

How do Smart Beta ETFs work?

Smart Beta ETFs use a rules-based approach to selecting stocks based on various factors. For example, a Smart Beta ETF that uses the value factor may select stocks with low price-to-earnings ratios or high dividend yields. A Smart Beta ETF that uses the momentum factor may select stocks with strong price momentum over the past six to twelve months. By using these factors, Smart Beta ETFs aim to achieve better risk-adjusted returns than traditional market-cap-weighted ETFs.

Compare ETF Brokers

Pros of Investing in Smart Beta ETFs

1. Better risk-adjusted returns: Smart Beta ETFs aim to achieve better risk-adjusted returns than traditional market-cap-weighted ETFs by using a rules-based approach to selecting stocks based on factors such as value, quality, momentum and low volatility.
2. Diversification: Smart Beta ETFs offer investors exposure to a diversified basket of stocks that are selected based on factors other than market capitalization.
3. Transparency: Smart Beta ETFs are transparent in their methodology for selecting stocks, allowing investors to understand how their investment is being managed.

Cons of Investing in Smart Beta ETFs

1. Higher expense ratios: Smart Beta ETFs tend to have higher expense ratios than traditional market-cap-weighted ETFs due to the additional research and management required to implement the rules-based approach.
2. Lack of track record: Smart Beta ETFs are a relatively new investment product, and as such, many of them have a limited track record compared to traditional market-cap-weighted ETFs.
3. Overfitting: There is a risk that the rules-based approach used by Smart Beta ETFs may be overfit to historical data and may not perform as expected in the future.

Types of Smart Beta ETFs

1. Value ETFs: Value ETFs use a rules-based approach to selecting stocks based on factors such as low price-to-earnings ratios or high dividend yields.
2. Quality ETFs: Quality ETFs use a rules-based approach to selecting stocks based on factors such as profitability, earnings quality, and financial stability.
3. Momentum ETFs: Momentum ETFs use a rules-based approach to selecting stocks based on strong price momentum over the past six to twelve months.
4. Low Volatility ETFs: Low Volatility ETFs use a rules-based approach to selecting stocks based on low volatility over the past twelve months.

Smart Beta ETF Benefits

Diversification with a Specific Focus: One of the most significant benefits of Smart Beta ETFs is the ability to diversify your portfolio while maintaining a specific focus. Instead of investing in a broad market index, Smart Beta ETFs allow investors to focus on a particular factor or strategy that they believe will outperform the broader market.

For example, an investor may choose to invest in a Smart Beta ETF that focuses on companies with a low volatility profile. By doing so, they are diversifying their portfolio with companies that have historically exhibited lower volatility while still maintaining a specific investment focus.

Lower Costs: Another significant benefit of Smart Beta ETFs is their lower cost compared to actively managed funds. While Smart Beta ETFs are actively managed to some extent, they still follow a rules-based methodology, which reduces the need for constant portfolio management by a fund manager. This results in lower fees, making Smart Beta ETFs an attractive option for cost-conscious investors.

Transparency: Smart Beta ETFs provide investors with transparency into the underlying holdings of the fund. The funds typically follow a rules-based methodology that is based on a specific factor or strategy. Investors can easily understand the criteria for inclusion in the ETF and can monitor the holdings to ensure that they align with their investment objectives.

Flexibility: Smart Beta ETFs provide investors with flexibility in terms of investment strategies. They offer exposure to a variety of factors such as low volatility, value, momentum and quality, among others. Investors can choose the factor or combination of factors that align with their investment objectives and risk tolerance.

Performance Potential: Smart Beta ETFs offer the potential for outperformance compared to traditional market-cap-weighted ETFs. By focusing on specific factors that have historically outperformed the broader market, Smart Beta ETFs offer the potential for higher returns.

Frequently Asked Questions