What Are Smart Beta ETFs?

Learn what smart beta ETFs are, how they work and their potential benefits and risks.

kent
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Research Lead
Reviewed by: Kent Thune
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Edited by: Kent Thune

Smart beta ETFs have emerged as a popular investment option for investors who are looking for an alternative to traditional passive index funds or actively managed mutual funds as well as the potential to outperform the market. In this article, we will discuss what smart beta ETFs are, how they work, and the benefits and risks of investing in them. 

What Is a Smart Beta ETF? 

A smart beta ETF is a type of exchange-traded fund that aims to outperform traditional market-cap-weighted index funds by using a rules-based approach to construct a portfolio. Unlike traditional index funds, smart beta ETFs do not rely solely on market capitalization to weight securities in the fund. 

Instead, smart beta ETFs use alternative weighting schemes based on factors such as value, momentum, quality, volatility and size to create a portfolio of securities that is designed to achieve specific investment objectives. 

For example, a smart beta ETF that follows a value-based strategy may seek to invest in stocks that are undervalued based on metrics such as price-to-earnings ratios or price-to-book ratios. A momentum-based smart beta ETF may invest in stocks that have shown a strong upward trend in recent months or years. 

How Do Smart Beta ETFs Work? 

Smart beta ETFs use a rules-based approach to select and weight securities in the fund. The rules are usually based on a set of quantitative factors that have been shown to generate excess returns over the long term. 

For example, a smart beta ETF may select stocks based on their dividend yield or earnings growth rate. The ETF may then weight the selected stocks based on the size of their dividends or their growth rates. 

The goal of this approach is to create a portfolio of securities that is more diversified and more responsive to changes in the market than a traditional market-cap-weighted index fund. 

Smart Beta ETF Management Styles 

Smart beta ETFs combine elements of both passive and active management styles. The passive style comes from tracking an index, while the active element involves choosing certain factors to select securities within the index. Within these styles, there are several types of smart beta ETFs, each of which uses a different set of factors and weighting schemes to construct a portfolio.  

The most common types of smart beta ETFs are: 

  • Value-based: Value-based smart beta ETFs select securities based on metrics such as price-to-earnings ratio, price-to-book ratio and dividend yield. The ETF may then weight the selected securities based on the size of their dividends or their earnings growth rates. 
  • Momentum-based: Momentum-based smart beta ETFs select securities based on their recent performance and the strength of their upward trend. The ETF may then weight the selected securities based on the strength of their momentum. 
  • Quality-based: Quality-based smart beta ETFs select securities based on metrics such as return on equity, debt-to-equity ratio and earnings stability. The ETF may then weight the selected securities based on their quality scores. 
  • Low-volatility-based: Low-volatility-based smart beta ETFs select securities with low levels of volatility or risk. The ETF may then weight the selected securities based on their volatility scores. 
  • Equal-weighted: Equal-weighted smart beta ETFs give each security in the portfolio an equal weighting, regardless of its market capitalization. This approach can provide more exposure to small cap stocks and may reduce concentration risk. 
  • Fundamental-based: Fundamental-based smart beta ETFs select securities based on a range of fundamental factors, such as revenue, cash flow and earnings. The ETF may then weight the selected securities based on their fundamental scores. 
  • Multifactor: Multifactor smart beta ETFs use a combination of two or more of the above factors to construct a portfolio. For example, a multifactor smart beta ETF may use a combination of value, momentum and quality factors to select and weight securities. 

It's worth noting that there can be overlap between different smart beta ETF management styles. For example, a multifactor smart beta ETF may use both value and momentum factors in its selection and weighting process. Investors should carefully review the prospectus and methodology of a smart beta ETF to understand how it is constructed and what factors and weighting schemes are used. 

The Benefits and Risks of Smart Beta ETFs 

Smart beta ETFs offer several benefits to investors, including the potential for higher returns. However, there are also several risks associated with these funds, such as complexity and potential for tracking error, that investors should consider before buying shares. 

Benefits of Smart Beta ETFs 

  • Potential for higher returns: Smart beta ETFs are designed to outperform traditional market-cap-weighted index funds by using alternative weighting schemes based on factors that have been shown to generate excess returns over the long term. 
  • Diversification: Smart beta ETFs provide investors with exposure to a diversified portfolio of securities that is designed to achieve specific investment objectives. 
  • Lower costs: Smart beta ETFs typically have lower expense ratios than actively managed mutual funds, making them a cost-effective investment option. 
  • Transparency: Smart beta ETFs are transparent, meaning that investors can see the securities held in the fund and the weighting schemes used to construct the portfolio. 

Risks of Smart Beta ETFs 

  • Complexity: Smart beta ETFs can be more complex than traditional market-cap-weighted index funds, which may make them more difficult for some investors to understand. 
  • Limited track record: Smart beta ETFs have a limited track record compared to traditional index funds and actively managed mutual funds, which may make it difficult to evaluate their performance over the long term. 
  • Potential for tracking error: Smart beta ETFs may deviate from their underlying index or investment objective, resulting in tracking error. 

Smart Beta vs. Standard Beta ETFs 

The main difference between smart beta and standard beta ETFs lies in their approach to constructing a portfolio. Standard beta ETFs aim to track a specific market index by weighting their holdings based on the market capitalization of the underlying securities. In contrast, smart beta ETFs use a rules-based approach to select and weight securities based on specific factors or characteristics, with the aim of outperforming the market. 

The main differences between smart beta and standard beta ETFs are: 

  • Methodology: Standard beta ETFs aim to replicate the performance of a market index, while smart beta ETFs use a variety of factors to build a portfolio. Smart beta ETFs may use a single factor, such as value or momentum, or a combination of factors, such as quality and low volatility. 
  • Diversification: Standard beta ETFs provide broad market exposure, which can help to diversify risk. Smart beta ETFs may provide exposure to a specific factor or characteristic, which may be less diversified than a market index. 
  • Performance: Standard beta ETFs aim to match the performance of the market index they track, while smart beta ETFs aim to outperform the market. Smart beta ETFs may perform better than standard beta ETFs in certain market conditions, depending on the factor or factors used to build the portfolio. 
  • Fees: The fees for smart beta ETFs are typically higher than those for standard beta ETFs due to the added research and analysis required to build the portfolio. 
  • Risk: Smart beta ETFs may be riskier than standard beta ETFs, depending on the factors used to construct the portfolio. For example, a momentum-based smart beta ETF may be more volatile than a market index during a market downturn. 

Bottom Line 

While smart beta ETFs may provide the potential for higher returns, they may also come with added risk and higher fees. Therefore, it's important for investors to carefully consider their investment goals and risk tolerance when choosing a smart beta ETF. 

Kent Thune is Research Lead for etf.com, focusing on educational content, thought leadership, content management and search engine optimization. Before joining etf.com, he wrote for numerous investment websites, including Seeking Alpha and Kiplinger. 

 

Kent holds a Master of Business Administration (MBA) degree and is a practicing Certified Financial Planner (CFP®) with 25 years of experience managing investments, guiding clients through some of the worst economic and market environments in U.S. history. He has also served as an adjunct professor, teaching classes for The College of Charleston and Trident Technical College on the topics of retirement planning, business finance, and entrepreneurship. 

 

Kent founded a registered investment advisory firm in 2006 and is based in Hilton Head Island, SC, where he lives with his wife and two sons. Outside of work, Kent enjoys spending time with his family, playing guitar, and working on his philosophy book, which he plans to publish in the coming year.