What Is a Smart Beta ETF?

A Smart Beta ETF is an exchange-traded fund (ETF) that uses a rules-based system for selecting investments to be included in the fund portfolio. An exchange-traded fund or ETF is a fund that tracks an index such as the S&P 500. Smart beta ETFs build on traditional ETFs and tailor the components of the fund's holdings based on predetermined financial metrics.

Weighting Strategies

Stocks that make up exchange-traded funds vary depending on the rules established at the fund's inception, and different weightings are assigned for each stock in a fund. Weighting means a fund might have more shares of one stock versus another based on an underlying aspect. ETFs might track a stock index that contains only bank stocks, large companies, or technology stocks.

Market-cap weighting is one of the most common methods in selecting how many shares of a company's stock comprise an index or fund. A company is chosen based on its market capitalization or share price multiplied by the number of outstanding shares. A company with many outstanding shares that experienced a high rise in stock price will weigh heavily in a market-cap index.

Smart Beta doesn't employ the typical cap-weighted index strategy but looks at factors specific to a particular company or industry. A smart Beta ETF might choose companies that only exhibit certain behaviors or metrics like earnings growth, the extent to which the stock moves up or down, or profitability. Each ETF employs rules that are part of an overall systematic approach to picking stocks to be included in the fund.

Types of Smart Beta ETFs

A smart Beta ETF may screen its holdings based on a company's dividend growth. Dividends are distributions paid to shareholders from the company's earnings as a reward for investing in the company. Companies that pay dividends tend to be large, well-established, and profitable.

Risk-weighted approaches account for the expected volatility in stocks. Funds might limit the holdings to low-volatility stocks to reduce risk in the fund. Volatility is a measure of how much a security's price fluctuates. There are many types of Smart Beta ETF strategies, including:

• Equally weighted: Instead of weighting the fund based on stock price and market capitalization, this strategy equally weights the factors and each holding.
• Fundamentally weighted: Companies are selected and weighted by such factors as total earnings, profits, revenue, or financially driven fundamentals and metrics.
• Factor-based: Stocks are weighted based on specific factors such as balance sheet components, underpriced valuations, or smaller companies that are growing.
• Low volatility: This method focuses on stocks and indexes with small price fluctuations over a historical period.

Passive and Active Management

Smart Beta ETFs use a combination of passive and active investing. Active investing employs an investment manager to choose stocks for a portfolio. An actively managed fund buys and sells stocks based on fundamental metrics like earnings or financial ratios.

A fund is when it tracks an index without having an investment manager choose the stocks. A fund might track all the stocks in the S&P 500 so that it mimics or tracks each move the S&P makes. Passive funds tend to have lower fees.

Smart Beta strategies are a blend of active and passive investing. The management is passive since it follows an index but considers alternative factors and actively chooses stocks or investments from within the index. A smart beta fund that tracks the S&P 500 index would not select every stock on the index. Instead, it might choose only those that exhibit a specific behavior, such as a percentage of revenue growth.

Benefits of Smart Beta ETFs

Many Smart Beta ETFs are designed to increase portfolio returns, maximize dividends, and lower portfolio risks. Equally-weighted indexing is considered one of the benefits of Smart Beta strategies. This parameter removes the emphasis on stocks in the index with the largest market-cap weightings. If the largest stocks or holdings underperform, they will have a sizable impact on the performance of the index relative to the smallest components of the index.

Smart Beta is not a passive strategy like the traditional market capitalization-weighted index funds. While many Smart Beta ETFs have higher expense ratios than passive index products, they are less expensive than most actively managed funds.Smart Beta ETFs are a common choice for investors hoping to maximize their income and returns while allowing for the potential to minimize risk.

Risks of Smart Beta ETFs

Smart Beta ETFs are a relatively new method of investing and exhibit low trading volumes. Low trading volume or liquidity means investors cannot sell or exit their positions. Trading costs can be high to re-establish the original index weighting. This price increase comes from the fund purchasing stocks to be included. As a result, the fees charged for smart Beta might be lower than actively managed funds, but the savings might not be significant.

Smart Beta ETFs can underperform traditional indexes, such as the S&P 500 since they must be consistently readjusted to the index. Holdings are added and sold based on the rules of the fund. Since Smart Beta ETFs have so many variables to consider, trading them can be more difficult than trading with traditional indexes, making the prices of Smart Beta ETFs vary from the fund's underlying value.

Example of a Smart Beta Fund 

The Vanguard Dividend Appreciation Index Fund ETF Shares (VIG) is a Smart-Beta ETF that tracks an index of stocks that pay dividends. The fund chooses companies from the S&P U.S. Dividend Growers Index.

The Smart Beta strategy is fundamentally weighted and includes the stocks of companies that exhibit a record of increasing dividends over time and hold the stocks in the index in approximately the same proportions as their weightings in the index. The expenses ratio is 0.06% and has companies from several industries including:

• Microsoft Corp.
• JPMorgan Chase & Co.
• Exxon Mobil Corp.
• Visa Inc.
• Johnson & Johnson

The Bottom Line

An exchange-traded fund tracks an index such as the S&P 500. Smart Beta ETFs build on traditional ETFs and employ investment strategies such as equal weighting, factor-based, and low volatility goals. Investors may invest in a Smart Beta ETF if they prefer an ETF that weighs both small-cap and large-cap stocks equally or an ETF that follows a low-volatility strategy.