- Smart beta ETFs can provide greater returns than traditional ETFs through factor investing.
- These funds can also reduce volatility by focusing on certain stocks or bonds.
- You can invest in smart beta ETFs through a brokerage account or employer retirement plan.
Investors can use exchange-traded funds (ETFs) to quickly diversify their portfolios by gaining exposure to major stock or bond market indexes. While more traditional versions of these funds provide exposure to benchmarks like the S&P 500, smart beta ETFs use factor investing in an effort to generate enhanced results over and above what index investing would provide.
Using rules-based methodologies to focus on stocks representing companies that have strong financial performance or significant growth prospects, for example, smart beta ETFs can potentially generate stronger returns or achieve lower volatility than more traditional indexes.
Beta measures the volatility of a specific asset compared with the broader market. This particular measure can give investors a sense of how volatile the asset will be. For example, a stock with a high beta relative to its index can potentially provide higher returns, but it might also suffer greater losses than similar stocks.
One way of determining an asset’s beta is evaluating its price movements relative to a specific index, such as the S&P 500. If a stock and the benchmark index go up by the exact same amount, the beta of that particular stock would be 1.
However, if the price of that stock climbs 75% when the broader index rises by 100%, the beta would be 0.75. Similarly, if the stock only increases 50% when the index goes up by 100%, its beta would be 0.5.
Investors can determine the beta of an asset, including an ETF, by making use of a specific formula that measures the returns of that asset relative to the market.
Traditional ETFs use market capitalization weighting to select stocks. A company’s market capitalization is the total value of all of its outstanding shares. When it comes to funds and asset selection, market capitalization weighting means that individual assets are included based on how much they contribute to an index.
When this methodology is used, the value of larger companies has a greater impact on the value of the index. If Apple Inc. makes up 5% of the S&P 500, for example, it will account for 5% of a traditional ETF that invests in the index.
Smart beta ETFs use different strategies. For example, some provide equal weight to every stock in the S&P 500. In this case, Apple Inc. would account for 0.2% of the index, or one five hundredth of it.
William Gogolak, an assistant teaching professor at Carnegie Mellon University, says smart beta ETFs are a “fantastic” way to obtain exposure to uncommon investing strategies. “They are especially useful if you are seeking unique return profiles that are not represented by passive funds,” he says.
Smart beta investing involves combining both passive and active investing strategies in order to generate higher returns, lower risk, or diversify more effectively. This approach involves starting with a passive index and then harnessing a rules-based methodology to make use of specific performance factors, such as a company’s size or financial health.
Smaller companies, for example, frequently have greater growth prospects than larger, more established ones. Therefore, their stocks might offer more compelling returns over time.
Alternatively, businesses with strong balance sheets, including consistent profitability and strong revenue, might outperform other companies and generate stronger returns.
Smart beta ETFs can give investors exposure to either stocks or bonds. In the case of bonds, a fund could start with a well-known bond index and then emphasize certain holdings in order to generate greater income than the benchmark index.
Types of smart beta ETFs
There are different kinds of smart beta ETFs that use various strategies to achieve their objectives. While some focus on stocks with strong financial performance, including earnings history, dividends, and cash flow, others include stocks that have had less volatility than the rest of the market.
Here are some common strategies:
- Equally weighted: This kind of smart beta ETF starts with an index and then provides equal weight to every component in that index. For example, an equally weighted smart beta ETF based on the S&P 500 would give each stock in that benchmark group 0.2% of the total fund value.
- Fundamentally weighted: These funds look at fundamental factors like a company’s cash flow or dividend history. A smart beta ETF focused on dividends, for example, could include the stocks of companies that have a long-term, proven track record of making these regular payments.
- Low volatility: Smart beta ETFs that use this strategy invest in assets with relatively low volatility. For example, one of these funds based on the S&P 500 might invest in 100 of the index’s 500 component stocks with the lowest volatility over the last year.
Smart beta ETF example
Vanguard’s High Dividend Yield ETF, a smart beta fund based on the S&P 500, contains stocks in the benchmark index that have produced above-average dividends. This fund, which includes common shares of over 400 stocks, had more than $58 billion in total assets as of July 31.
This particular fund lists financials, healthcare, and consumer staples as its largest sectors, which account for 19.4%, 15.5%, and 13.4% of its exposure, respectively. Collectively, these three industries make up close to 50% of the fund’s holdings.
Shares of this ETF, which trade under the ticker symbol VYM, have an expense ratio of 0.06%. This fund paid three-year, five-year, and 10-year returns of 8.61%, 8.80%, and 11.18% through the second quarter of 2022.
For the sake of comparison, the SPDR S&P 500 ETF Trust, a well-known fund that trades under the symbol SPY and has been around since 1993, produced three-year, five-year and 10-year returns of 13.36%, 12.83% , and 13.80% as of July 31, 2022.
Pros and cons of smart beta ETFs
Smart beta ETFs can potentially provide higher returns, lower risk, and greater diversification than other investing methods. However, these ETFs are not without their drawbacks. One major criticism of these funds is that some investing strategies could be more transparent.
“To grasp these instruments, you must read the prospectus, which is often lengthy and written with complicated legal language,” Gogolak says.
Here’s a look at the pros and cons.
How to invest in a smart beta ETF
Interested parties can purchase shares of smart beta ETFs through a brokerage or retirement account. You can open one of these accounts through a financial institution or your employer.
Before buying a smart beta ETF, be sure to conduct the proper due diligence to make sure it’s appropriate for your goals, risk tolerance, and time horizon.
If you think it will help you make the right decision, consider seeking help from an investment professional. When you’ve selected a smart beta ETF that fits your needs, you can buy it using the same process you would to buy stocks.
The bottom line
Smart beta ETFs combine active and passive investing to provide access to a wide range of enhanced strategies that make use of factor investing in an effort to generate better results than passive funds. They can potentially outperform more traditional, market-cap-weighted approaches, offering more compelling returns, broader diversification, or lower risk.
While smart beta ETFs have been marketed as a way of generating superior results, this does not always materialize in practice, according to academic research published in 2020. Once smart beta ETFs go live, data shows, the performance of their underlying index can decrease significantly .
One way investors can manage such potential pitfalls is by evaluating the actual historical performance of any smart beta ETF they are considering, instead of relying on figures generated by backtesting.
As always, investors interested in smart beta ETFs can benefit greatly from conducting substantial due diligence on funds before purchasing them, and potentially speaking with an investment professional to get their input.