Smart Beta ETFs
Smart beta ETFs, also known as "strategic beta" or "factor-based" ETFs, use rules-based indexes. They are a low-cost way to access smart beta strategies.
Smart beta ETFs (exchange-traded funds) screen and weight securities based on factors other than market capitalization.
Most of the major indexes (e.g., S&P 500® Index, Russell 1000® Index, Russell 2000® Index, MSCI EAFE Index) are market-cap weighted, meaning that the largest companies have the largest weight in the underlying index. Smart beta or strategic beta represents a different way of constructing the index basket. Popular strategic beta strategies include equal weighting, fundamental weighting, minimum variance, and low volatility. Smart beta strategies vary based on the universe from which securities are selected, economic (or other) factors screened, and weighting methodologies.
By under- or overweighting particular types of stocks, a smart beta strategy could coincide with your own view of the market. For example, you might want an equal-weight ETF if you believe a tilt toward smaller-cap companies makes sense. Alternatively, if you think the markets are about to get choppy and low-volatility stocks will be valued by other investors, you might want to invest in a low-volatility strategy.
What are the different types of smart beta ETFs?
Smart beta ETFs can be broken down into three subcategories: risk-oriented, return-oriented, and other. While there are numerous types of smart beta ETFs, here are some common ones:
Low-volatility ETFs - Weight stocks based on their level of historical or predicted volatility over a specified period, such as one year.
Momentum ETFs – Weight stocks based on their price momentum over a specified period.
Quality ETFs – Weight stocks based on strong balance sheet characteristics, such as low debt, consistent earnings, and high levels of profit measures (e.g., return on equity).
Fundamental ETFs - Weight stocks based on accounting factors, such as sales, cash flow, and dividends plus buybacks.
Equal-Weight ETFs - Provide the same weight to every stock in a given index at the time of the index rebalance (stocks may drift away from equal weighting between rebalances).
What are the pros and cons of smart beta ETFs?
As you make decisions about your portfolio, it’s important to understand what smart beta ETFs can offer and what to watch out for.
Potential for enhanced returns
Smart beta ETFs attempt to blend the low costs and discipline of passive management with the potential to outperform a market-cap-weighted index.
Not all smart beta strategies are created equal, and there will be performance differences based on market conditions. In some market environments, market-cap-weighted ETFs may actually outperform smart beta ETFs.
When looking at the past performance of smart beta ETFs (or the indexes they track), it's important to distinguish between actual and back-tested returns (the returns an index or ETF would have generated if it had been in existence). Since we have complete and accurate information about prior market conditions, it's possible that an index was constructed with a focus on the rearview mirror. In other words, the rules defining the index were chosen in order to provide what would have been strong performance in a prior period, but there’s no guarantee those conditions will continue or recur in the future.
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