Smart beta exchange-traded funds are emerging as a popular option for some investors who are seeking a strategy to diversify their portfolio without relying on the standard index funds which focus only on stock or sector concentration.
Typical index funds are weighted by market cap and the indices will overweight the largest stocks.
Smart beta ETFs provide a lower risk, greater tax efficiency and give investors more flexibility to trade in and out of them compared to standard mutual funds.
These products represent a "middle ground on the active-to-passive spectrum—they deviate from a traditional, strictly passive market portfolio, but do so in a rules-based, transparent, and relatively low-cost manner," according to a report by Morningstar, a Chicago-based independent investment research provider.
Here are five reasons why investing in smart beta ETFs can be advantageous.
A smart beta ETF has the ability to invest in thousands of stocks to deliver the exact risk-return combination an individual seeks, but in a more more efficient and less costly fashion, said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla.
"It is always better to buy a share of a smart beta ETF which owns thousands of stocks then to buy a small fraction of one share for each of the thousands of stocks," he said. "While beta is a measure for risk, market beta is the amount of market risk an investor chooses to take."
The strategies can offer investors a greater risk-return tradeoff than traditional passive ETFs by taking a factor-weighted approach rather than weighting by capitalization like passive products, said Joe Sullivan, director of manager relations at Covestor, the online investing division of Interactive Brokers, which is based in Greenwich, Conn.
Instead of ranking stocks by their market value, smart beta constructs indexes which rank them by traits or other factors, he said. The factors includes ones such as value, momentum, volatility, dividend yields or other financial metrics which have historically performed better compared to the market and reduced risk, Sullivan said.
"Some people believe the traditional approach of weighting companies just based on their market value delivers sub-par returns," he said.
Smart beta ETFs offer an "unique access to different risk levels within an all equity approach," said Edison Byzyka, chief investment officer of Hefty Wealth Partners, a financial planning firm in Auburn, Ind. "It is also a cheap alternative to basic capitalization weighted passive investing."
The fees for ETFs are more enticing than mutual funds. The fees for a traditional ETF are 0.25% or less while smart beta ETFs are often 0.50% or less compared to mutual funds which charge fees of 0.50% to 1.00%.
Some smart beta products have management fees of 0.08% annually, which is $8 on a $10,000 investment, Sullivan said.
These ETFs can increase market diversification easily for an investor's portfolio, Sullivan said. ETFs are a nimble investment, especially for retail investors who want broader exposure to various sectors and industries.
While each smart beta fund is "smartly constructed to deliver a pre-specified risk-return payoff," investors need to know what they are getting into, said Ma.
"Investors need to do their homework, too," he added. "Smart beta funds refer to the smart way to deliver your choice payoff. Each investor will need to decide which risk and at what level they can tolerate. Investing in smart beta funds or ETFs is like picking a personal and unique position from infinite amount of risk and return combinations."