ETF Jargon Simplified

We break down differences between smart-beta, thematic and ESG funds.

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Reviewed by: Todd Rosenbluth
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Edited by: Todd Rosenbluth

With $3.7 trillion in U.S. exchange-traded products spread across more than 2,200 funds, it’s easy to think investors and advisors have a strong understanding of the ETF industry jargon we use in CFRA Thematic Research articles.

But we’re regularly reminded that not everyone has soaked this all in. As such, we’re pausing to review how we think of some catchphrases that are commonly used in our commentary and by asset managers. Hopefully as you sort through the ETF universe, with CFRA’s help, this jargon will not seem so foreign to you.

ESG

One of the most misunderstood pieces of jargon is a new term, or acronym, “ESG,” which those in the ETF industry understand, but less so on a retail level.

The supply of environmental, social and governance (ESG) ETFs continues to grow and yet the asset base for these products remains collectively small with approximately 0.2% of overall assets—partially because many people are less familiar with what is inside these ETFs.

Broadly diversified examples, such as the iShares MSCI U.S.A. ESG Select ETF (SUSA) and the Vanguard ESG U.S. Stock ETF (ESGV), hold stocks that score favorably based on multiple ESG criteria and exclude a few areas such as tobacco or weapons.

The scoring incorporates analytics on climate change, consumer protections, corporate governance, labor management, product liability and many others. The X-trackers MSCI U.S.A. ESG Leaders Equity ETF (USSG) launched last week, and quickly exceeded $840 million in assets due to its connection with a European institutional investor.

Meanwhile, other ESG ETFs focus on just the E [environment], the S [social] or the G [government] in the acronym. These include:

Market Cap Weighted

Microsoft, Apple and Amazon are the largest U.S.-listed stocks based on a market capitalization. The metric is calculated by multiplying the stock price by the shares outstanding.

Due to their size, they are the largest stocks in the S&P 500 Index or the Russell 1000 Index, which is tracked by the SPDR S&P 500 ETF Trust (SPY) and the iShares Russell 1000 ETF (IWB). Meanwhile, Nestle, Novartis and Roche Holdings are the largest stocks within the indexes behind the iShares MSCI EAFE ETF (EFA) and the Vanguard FTSE Developed Markets ETF (VEA). There are hundreds of other stocks inside these ETFs, but their weightings are smaller than MSFT and Nestle solely due to the overall value of the stocks.

(See our ETF Stock Finder, which helps you find an ETF’s allocation to a single stock.)

While it’s common for many active strategies to hold hefty stakes in the largest-cap companies, management uses discretion to have more or less exposure to an individual stock based on fundamental or momentum reasons. In contrast, managers of market-cap-weighted index-based ETFs own the stocks in relation to their place in the broader market.

Smart Beta

Any ETF that is not market-cap weighted generally is referred to as a smart-beta fund. This term encompasses a wide variety of approaches and involves transparency about the index’s rules.

For example, equally weighting the securities inside a fund is a common smart-beta approach. The Invesco S&P 500 Equal Weight ETF (RSP) holds the exact same stocks as the iShares Core S&P 500 ETF (IVV), but instead of a 3.7% weighting in Microsoft and a 0.13% weighting in the more moderately sized Xilinx, RSP hold 0.2% of assets in both tech companies).

Equal-weighted strategies rebalance to realign positions, while market-cap-weighted ones don’t. Many industry-oriented ETFs, such as the SPDR S&P Semiconductor ETF (XSD), are equally weighted.

Other smart-beta approaches focus on a stock’s relative valuation, fundamentals or trading patterns.

These include the iShares Edge MSCI U.S.A. Value Factor ETF (VLUE), the Vanguard High Dividend Yield ETF (VYM) and the Invesco S&P 500 Low Volatility ETF (SPLV), with a narrow number of constituents qualifying for inclusion. Smart-beta ETFs are reconstituted at scheduled times, though some are quarterly and others semiannually or annually.

There are far fewer stocks inside a smart-beta ETF than a market-cap-weighted one, which can result in relative out- or underperformance for the broader market in a given period of time.

Multifactor

Some smart-beta ETFs are also known as factor ETFs because they’re built based on metrics that have historically performed well. Multifactor ETFs quantitatively combine a few of these approaches (dividends, low volatility, momentum, quality, size and value) as part of the screening criteria and help offset the likelihood for wide performance gaps. This is also closer to the experience of an actively managed fund, since most stock selection decisions by humans incorporate multiple fundamental and valuation approaches.

A few of the numberous multifactor options include:

Thematic

Some ETFs fall into a broad thematic bucket, as they focus on long-term trends, such as cybersecurity, robotics and internet usage.

These ETFs usually cross over the traditional GICS [Global Industry Classification Standard] sector lines, because stocks in multiple sectors can qualify as candidates to benefit from the theme.

Yet these are still narrower slices of the market, and investors can often find them at the top or the bottom of the performance tables in any given period.

Among the more popular thematic funds are:

This article was originally published on MarketScope Advisor on March 11, 2019. Visit www.cfrearesearch.com to learn more.

Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence’s equity and fund business in October 2016. Follow him at @ToddCFRA.