In the world of investing, there are countless strategies and products available to help investors build wealth and achieve their financial goals. One such product that has grown in popularity in recent years is the smart beta ETF. In this article, we will explore what a smart beta ETF is, how it works, and the benefits and risks of investing in one.

What is a Smart Beta ETF?

A smart beta ETF is a type of exchange-traded fund that seeks to provide investors with better risk-adjusted returns than traditional index funds. Unlike traditional index funds that simply track a benchmark index, smart beta ETFs use a methodology that seeks to identify and capture specific factors or traits that could drive market outperformance over time.

Smart beta ETFs can target a range of factors, from value and momentum to quality and low volatility. By tilting towards these factors, smart beta ETFs aim to deliver higher risk-adjusted returns than traditional index funds over the long term.

One of the advantages of smart beta ETFs is that they offer investors a more targeted approach to investing. For example, an investor who believes that value stocks are currently undervalued can invest in a smart beta ETF that targets value stocks. This allows the investor to potentially benefit from the outperformance of value stocks without having to pick individual stocks themselves.

How Smart Beta ETF Works

The beta refers to the historical correlation between the ETF and a specific market index. Smart beta ETFs adjust this correlation based on additional factors. Once these factors are identified, the Smart Beta ETFs will then weight them differently when compared to the market index. When there is overexposure to a particular sector or company, smart beta ETFs will tend to adjust their weightings and either reduce or increase exposure to the same to maintain an equilibrium.

For example, a smart beta fund that targets value stocks may use various valuation metrics to identify and overweight stocks that appear undervalued relative to their peers. By overweighting these undervalued stocks, the fund aims to generate higher long-term returns than a traditional index fund that simply tracks a broad index like the S&P 500.

Another factor that smart beta ETFs may consider is the volatility of individual stocks. By adjusting the weightings of stocks based on their volatility, smart beta ETFs can potentially reduce overall portfolio risk. Additionally, some smart beta ETFs may incorporate environmental, social, and governance (ESG) factors into their investment strategies, allowing investors to align their investments with their values.

Benefits of Investing in Smart Beta ETFs

One of the main benefits of investing in a smart beta ETF is that it can offer investors a means of obtaining a diversified portfolio that is exposed to specific factors that are believed to drive market outperformance over time.

Smart beta ETFs use a rules-based methodology that seeks to identify and capture targeted factors such as value, momentum, and quality, among others. By tilting towards these factors, smart beta ETFs can potentially deliver higher risk-adjusted returns over the long term than traditional index funds.

Another advantage of smart beta ETFs is that they tend to have lower fees than actively managed funds. This is because smart beta ETFs are still passively managed, meaning they don’t require the same level of research and analysis as actively managed funds.

Additionally, smart beta ETFs can provide investors with a more transparent investment strategy. The rules-based methodology used by smart beta ETFs is often publicly available, allowing investors to better understand how their money is being invested and what factors are being targeted.

Furthermore, smart beta ETFs can offer investors a way to invest in specific sectors or themes, such as clean energy or technology. This allows investors to align their investments with their personal values or interests, while still benefiting from the potential outperformance of targeted factors.

Understanding the Different Types of Smart Beta ETFs

There are various types of smart beta ETFs available in the market, and each may target a different factor or strategy. Some of the most common types of smart beta ETFs include:

• Value-centered ETFs: These ETFs focus on identifying stocks that are undervalued by the market and trading at a discount to their intrinsic value.
• Momentum ETFs: These ETFs invest in stocks that have recently had strong price momentum.
• Low-volatility ETFs: These ETFs invest in stocks that have low levels of volatility and tend to outperform during periods of market volatility.
• Quality ETFs: These ETFs invest in stocks of companies with strong financials, stable earnings growth and low debt levels.

Another type of smart beta ETF is the Dividend ETF. These ETFs invest in stocks of companies that pay high dividends. Dividend ETFs are popular among investors who are looking for a steady stream of income.

Factor-based ETFs are also a type of smart beta ETF. These ETFs invest in stocks that exhibit certain characteristics, such as low volatility or high momentum. Factor-based ETFs are designed to capture specific market factors that have historically led to outperformance.

How to Choose the Right Smart Beta ETF for Your Portfolio

Choosing the right smart beta ETF for your portfolio involves assessing your investment goals, risk tolerance, and time horizon. Factors that should be considered include the ETF’s management style, fee structure, performance history, and expense ratio.

Investors should also consider the market context and potential for future growth or decline before investing in a smart beta ETF.

Another important factor to consider when choosing a smart beta ETF is the underlying index that the ETF tracks. Some smart beta ETFs track well-known indexes, while others track custom indexes created by the ETF provider. It’s important to understand the methodology behind the index and how it aligns with your investment goals.

Additionally, investors should consider the diversification benefits of adding a smart beta ETF to their portfolio. Smart beta ETFs can provide exposure to specific factors or themes, such as low volatility or environmental sustainability, that may not be present in traditional market-cap weighted ETFs.

Risks and Limitations of Investing in Smart Beta ETFs

While smart beta ETFs can offer potential benefits to investors, it is important to consider the risks and limitations of investing in these funds. One such risk is that the outperformance of a particular factor may not last for an extended period of time.

Additionally, smart beta ETFs may underperform during market downturns or periods of heightened volatility. Furthermore, there is no guarantee that a smart beta ETF will outperform its benchmark index or that it will deliver higher returns than a traditional index fund.

Another limitation of smart beta ETFs is that they may have higher expense ratios compared to traditional index funds. This is because the process of selecting and weighting securities based on certain factors requires more research and analysis, which can result in higher management fees.

Comparing Smart Beta ETFs with Traditional Index Funds and Active Management

Smart beta ETFs offer a middle ground between the benefits of traditional index funds and the potential for outperformance of active management. Compared to traditional index funds, smart beta ETFs offer the potential for higher returns through targeted exposure to specific factors that have historically driven outperformance.

Compared to actively managed funds, smart beta ETFs offer lower costs and a rules-based approach that is designed to avoid the pitfalls of active management, such as high fees and manager bias.

One of the key advantages of smart beta ETFs is their ability to provide investors with exposure to a wide range of asset classes and investment strategies. For example, some smart beta ETFs focus on dividend-paying stocks, while others target companies with low volatility or high momentum. This allows investors to tailor their portfolios to their specific investment goals and risk tolerance.

Another advantage of smart beta ETFs is their transparency. Unlike actively managed funds, which may hold a wide range of securities and may not disclose their holdings on a regular basis, smart beta ETFs typically hold a more limited number of securities and disclose their holdings on a daily basis. This allows investors to better understand the risks and potential rewards of their investments.

Top Performing Smart Beta ETFs to Watch in 2021

Here are some of the top-performing smart beta ETFs to keep an eye on in 2021:

• iShares Edge MSCI USA Value Factor ETF (VLUE)
• Invesco S&P 500 Equal Weight ETF (RSP)
• Xtrackers MSCI EAFE ESG Leaders Equity ETF (EASG)
• Vanguard High Dividend Yield ETF (VYM)

Smart beta ETFs are a type of exchange-traded fund that uses a rules-based approach to investing. They aim to provide investors with exposure to specific factors or investment strategies, such as value, momentum, or low volatility. These ETFs have gained popularity in recent years as investors look for ways to diversify their portfolios and potentially enhance returns.

Tips for Successful Investing in Smart Beta ETFs

Here are some tips to help investors successfully invest in smart beta ETFs:

• Understanding the methodology and strategy used by the smart beta ETF.
• Ensuring that the smart beta ETF aligns with your investment goals and risk tolerance.
• Regularly reviewing the performance and holdings of the smart beta ETF to ensure that it continues to fit your investment criteria.
• Using smart beta ETFs in conjunction with other investment products to build a diversified portfolio.

Overall, smart beta ETFs can be a useful tool for investors seeking a more targeted approach to investing and potentially higher returns over the long term. As with any investment product, it is important to fully understand the risks and limitations before investing and to choose a product that aligns with your investment goals and risk tolerance.

One important factor to consider when investing in smart beta ETFs is the fees associated with the product. While smart beta ETFs can offer a more targeted approach to investing, they may also come with higher fees compared to traditional index ETFs. It is important to weigh the potential benefits of the smart beta strategy against the fees charged by the ETF provider.

Another consideration when investing in smart beta ETFs is the potential for tracking error. Smart beta ETFs may deviate from their underlying index or strategy, which can result in tracking error and potentially lower returns. Investors should carefully review the ETF’s historical performance and track record to assess the level of tracking error and determine if it aligns with their investment goals.