What Are Smart Beta ETFs and How Do They Work for Investors?

By Hetal Bansal

Smart Beta ETFs Exchange traded fund

Smart Beta ETFs (Exchange Traded Funds) are a relatively new type of investment vehicle that have gained popularity in recent years. Unlike traditional ETFs, which track market indexes such as the S&P 500, Smart Beta ETFs use alternative weighting schemes and other factors to create investment portfolios that are designed to outperform the market. The goal of Smart Beta ETFs is to provide investors with a better risk-adjusted return than traditional ETFs, while also offering diversification benefits and the potential for lower fees. As the demand for alternative investment strategies continues to grow, Smart Beta ETFs are becoming an increasingly popular option for investors looking to achieve their financial goals.

 

What Are Smart Beta ETFs and How Do They Work?

 

Man using smart phone with icons of ETF

 

Smart Beta ETFs are a type of exchange-traded fund that use alternative weighting schemes and other factors to create investment portfolios that are designed to outperform traditional ETFs. These ETFs use a rules-based approach to create portfolios that are based on specific investment criteria, such as value, momentum, low volatility, or quality. Smart Beta ETFs are designed to provide investors with a better risk-adjusted return than traditional ETFs, while also offering diversification benefits and the potential for lower fees.

Smart Beta ETFs work by using a rules-based approach to create investment portfolios that are designed to outperform the market. These ETFs use a variety of different weighting schemes and other factors to determine which stocks to include in their portfolios. Some Smart Beta ETFs use a value-based approach, which means they focus on stocks that are undervalued relative to their intrinsic value. These ETFs may use metrics such as price-to-earnings ratios or price-to-book ratios to identify undervalued stocks.

Other Smart Beta ETFs use a momentum-based approach, which means they focus on stocks that have performed well in the past and are likely to continue to perform well in the future. These ETFs may use metrics such as price momentum or earnings momentum to identify stocks that are likely to outperform market.

Another approach used by Smart Beta ETFs is the low volatility approach, which means they focus on stocks that have historically had lower volatility than the market as a whole. These ETFs may use metrics such as beta or standard deviation to identify stocks that are likely to have lower volatility than the market.

Finally, some Smart Beta ETFs use a quality-based approach, which means they focus on stocks that have strong financial fundamentals and a track record of profitability. These ETFs may use metrics such as return on equity or return on assets to identify high-quality stocks.

Once the criteria for the Smart Beta ETF has been established, the ETF will construct a portfolio that meets those criteria. The portfolio will typically be constructed using a weighting scheme that is designed to achieve the desired investment outcomes. For example, a Smart Beta ETF that is focused on value stocks may use an equal-weighted or a fundamentally weighted approach to construct its portfolio.

Once the portfolio has been constructed, the Smart Beta ETF will typically rebalance the portfolio periodically to ensure that it continues to meet the desired investment outcomes. Rebalancing may occur on a quarterly, semi-annual, or annual basis, depending on the specific Smart Beta ETF.

 

The Pros and Cons of Investing in Smart Beta ETFs

 

Pros of Investing in Smart Beta ETFs

  • Improved risk-adjusted returns: Smart beta strategies are designed to improve the risk-return tradeoff in investors portfolios by offering superior risk-adjusted returns compared to traditional market-cap-weighted ETFs. Smart beta ETFs invest in factors that have historically outperformed the market, such as value, momentum, quality, or volatility.
  • Diversified exposure: Smart beta ETFs offer investors diversified exposure to a specific market segment that would not be possible with a single stock or traditional ETF. Smart beta ETFs provide investors access to a portfolio of stocks that are weighted based on certain factors, resulting in a more diversified portfolio that minimizes the risk of investing in individual stocks.
  • Lower fees: Smart beta ETFs tend to have lower fees compared to actively managed funds. They are also more cost effective than traditional ETFs because they have lower turnover rates, resulting in reduced transaction costs.
  • Transparency: Smart beta ETFs are transparent and make it easy for investors to understand their holdings and performance. They disclose their methodology and holdings publicly, making it simple for investors to assess their exposure to specific factors.

Cons of Investing in Smart Beta ETFs

  • Limited Outperformance: While smart beta ETFs have the potential to outperform the market, there is no guarantee that they will do so consistently over time. The outperformance that they have experienced in the past is mainly due to the favorable market environment.
  • Sector Concentration: Smart beta ETFs may be more prone to sector concentration. ETFs based on value or growth factors may be heavily concentrated in specific sectors, such as financial services or technology, which may pose risks in the event of a market downturn.
  • Lack of customization: Smart beta ETFs are designed to follow specific rules-based investment strategies, which limits customization for investors who wish to invest in a specific sector or theme.
  • Exposure to new sector risks: Smart beta ETFs may expose investors to new types of risks, such as liquidity risk, as they may hold illiquid stocks. They may also be exposed to factors that they may not have considered, such as political or country risk.

How to Choose the Right Smart Beta ETF for Your Investment Portfolio

 

Man using smart phone with ETF Exchange traded fundChart

 

Identify your investment goals

Before you even start looking at smart beta ETFs, you need to know what your investment goals are. Do you want to invest in the stock market for long-term growth? Are you looking for income? Or are you more interested in minimizing risk? Once you have a clear understanding of your investment goals, you can decide which smart beta ETFs best align with those goals.

Determine your risk tolerance

Investment portfolios are not one-size-fits-all. Every investor has a different risk tolerance, which determines how much risk they are comfortable taking on. Some smart beta ETFs, such as those that focus on low-volatility or quality companies, tend to be less risky than others. On the other hand, ETFs focusing on momentum or small-cap stocks tend to have higher risk levels. Understanding your risk tolerance will help you choose smart beta ETFs that align with your comfort level.

Consider costs

While smart beta ETFs are a cost-effective way to invest in the stock market, there are still costs associated with them. The expense ratio, or the annual fee charged by the ETF provider, is the most obvious cost. However, there may be additional fees for transactions, such as buying or selling shares, and management fees. Before investing in a smart beta ETF, make sure to understand all of the potential costs associated with it.

Choose your factor

One of the primary reasons investors turn to smart beta ETFs is to gain exposure to certain factors, such as value, momentum, or low volatility. Depending on your investment goals, you may want to focus on one or several factors. For example, if you are looking for a less risky investment with steady returns, a low-volatility ETF may be the right choice for you. Alternatively, if you are looking for growth potential, you may want to consider ETFs focusing on momentum or growth stocks.

Evaluate historical performance

While historical performance is not a guarantee of future performance, it can provide insight into an ETF's potential return. Look at an ETF's historical performance over a period of time, such as five or ten years, to determine its performance relative to its benchmark index. Also, look at the ETF's performance during both up and down markets to see how well it performs under different market conditions.

Check the ETF's holdings

An ETF's holdings provide insight into the types of stocks it invests in, and whether those align with your investment goals. Make sure to review an ETF's holdings to see if it is investing in the types of companies and industries that you are interested in. Additionally, make sure to check the ETF's top holdings to see if it is overly allocated in one or a few companies, which could increase risk.

Consider diversification

One of the benefits of investing in ETFs, including smart beta ETFs, is diversification. Smart beta ETFs often have a different mix of stocks than traditional index-tracking ETFs, which can provide additional diversification. However, it is important to ensure that you are not overweighted in a particular industry or sector. Make sure to review an ETF's sector breakdown to ensure that you are not overly concentrated in one area.

Look at the ETF provider

The provider of an ETF can also provide some insight into its quality. Choose ETFs from reputable providers with a strong track record of performance and reliability. Additionally, look for ETF providers that have a focus on investor education and transparency.

Consider tax implications

While ETFs typically have lower tax implications than mutual funds, you still need to consider the potential tax consequences of investing in a smart beta ETF. Some ETFs may generate more capital gains than others, which could affect your taxes. Additionally, some smart beta ETFs may have higher turnover rates, which could lead to higher tax bills.

 

Conclusion

In conclusion, Smart Beta ETFs represent an exciting development in the world of investing, offering investors the potential for better risk-adjusted returns than traditional ETFs. These ETFs use alternative weighting schemes and other factors to create portfolios that are designed to outperform the market. While Smart Beta ETFs are still a relatively new investment vehicle, they have already gained significant popularity among investors due to their potential for diversification and lower fees. As the demand for alternative investment strategies continues to grow, it is likely that Smart Beta ETFs will become an even more important part of investors' portfolios. However, it is important for investors to do their due diligence and carefully consider the risks and benefits of these investments before making any investment decisions.