Stay smart about smart beta

By Xavier Brenner

Smart beta strategies have caught on with investors, with more than 450 US-listed smart beta products in the market with some $510 billion in assets, according to investment research firm Morningstar .

Smart beta ETFs are carefully constructed indexes that rank stocks by traits other than their market value, the standard methodology employed by traditional benchmarks, such as the Standard & Poor's 500.

Instead, these products focus on "factors," such as growth, value, dividends, volatility or other financial metrics that offer the possibility of market-beating performance and reduced portfolio risk.

Like any other financial product, however, investors need to carefully weigh the pros and cons. Here are some questions you ought to be asking:

 

What's the underlying strategy?

Some smart beta indices are pretty straightforward, but others are based on complex methodologies. Index components can be weighted by companies’ revenues, dividends, volatility or other corporate variables and skew toward small caps or large caps.

Read the prospectus, check out the provider's website and consult an investment professional, if need be, to make sure you're adequately informed before diving in.

How much does this smart beta strategy cost?

Investment firms are quick to point out smart beta strategies are typically less expensive than actively-managed funds. That said, they generally cost more than passive, market-cap-weighted indices.

Smart beta indices are rule-based and rebalance their holdings on a regular basis to keep their underlying strategy on track. This turnover can increase investor costs. Fees and commissions, even modest ones, eat into returns. So get an accurate read on the fee and commissions structure from the provider.

 

Be skeptical of back-tested performance claims

Many alternatively weighted index strategies are new products with little in the way of a track record. So ETF providers often do back-testing by applying a mathematical model to historical market data.

Such data-crunching can provide useful insights into the potential strengths of a smart beta strategy. Yet, keep in mind that it doesn't predict or guarantee future performance. The same holds true of academic research some financial companies roll out in their marketing materials to promote their products.

What are the liquidity risks with the smart beta strategy?

Some smart beta index products are new and may be thinly traded and have wide bid/ask spreads.

Also, keep in mind that the liquidity of the underlying components of the product tracking the smart beta ETF is a risk worth considering.

Takeaway

The popularity of smart beta strategies is one of hottest trends in personal investing right now.

When designed carefully, these products can give your portfolio a possible performance edge at a reasonable cost.

Yet, investors should read the fine print and understand the underlying strategy and risk of any alternative index product.

Do the upfront research. It pays to be smart about smart beta.

Photo Credit: Pictures of Money via Flickr Creative Commons

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