Smart beta has caught on in recent years as a tool in the portfolios of many investors and with financial advisors. Between Q4 2016 and Q4 2017, the number of smart beta exchange-traded funds (ETF) ballooned by 22%. Since that time, the space has only continued to grow. There are more than 1300 available to investors as of late 2018.

As a financial advisor looking to incorporate smart beta into client portfolios, how do you explain the benefits of using these strategies to them?

Factor Investing

Smart beta ETFs are, for the most part, variations on the more common market cap-weighted index ETFs that are so widely available. Most smart beta ETFs use factors as their investment strategy. These funds can be focused on a wide variety of factors, including the following:

  • Quality: Stocks of companies with sound financials exhibiting consistent growth in earnings and a solid balance sheet.
  • Value. The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued.
  • Momentum. Momentum investing is an investment strategy that aims to capitalize on the continuance of existing trends in the market. The momentum investor believes that large increases in the price of a security will be followed by additional gains and vice versa for declining values.
  • Size. Generally smart beta ETFs following this factor style invest in stocks with smaller market capitalizations than their peers—for example, mid and large-cap stocks.
  • Low volatility. Typically, ETFs following this factor style will invest in stocks within a benchmark like the S&P 500 that exhibit lower than average volatility.

The underlying benchmarks behind factor-based smart beta ETFs and mutual funds are typically slices of traditional market-cap-weighted indexes like the S&P 500. For example, the iShares MSCI USA Quality Factor ETF (QUAL) tracks an index of large and mid-cap stocks that exhibit high returns on equity, low debt/capital ratios and low variability in the growth of their earnings over the prior five years compared to their peers.

Smart Beta and Traditional Indexing

At its core, smart beta is based upon indexing. Where it differs from traditional market cap weighted indexing like that used in the typical S&P 500 index fund or other standard index products, is that by using a factor approach investors gain more exposure to certain segments of an index or asset class. This ability to hone in on various factors also carries its own set of risks such as concentration risk in certain areas such as stocks of a given size or level of volatility.

However, like traditional indexing, smart beta ETFs employ a set methodology for selecting stocks in which to invest in. In the case of a traditional market cap-weighted index fund, this is the relative weighting of a given stock to its benchmark index. Smart beta ETFs and funds do the same thing, except they use a customized selection criterion that goes along with the customized benchmark that is generally created for the ETF. 

Like traditional indexing, smart beta ETFs can also offer transparency and tax efficiency in taxable accounts.


Smart beta funds allow investors to hone in on various sub-segments of asset classes. This can help financial advisors focus on objectives such as reducing volatility, increasing the overall quality of the portfolio’s holdings and others. Smart beta can easily be used in combination with other funds and investments such as traditional index products, actively-managed funds, alternative products, and individual stocks and bonds that you might use to build an overall investment strategy for your clients. 

Smart beta ETF provider Wisdom Tree lists four potential advantages of smart beta strategies:

  • Enhanced portfolio returns
  • Reduced portfolio risks
  • Increased dividend income
  • More efficient exposure to the equity risk premium

Portfolios comprised of traditional long-only index funds with smart beta products across several investing factors can be used to fine-tune a portfolio to better reflect the objectives of your client.

Active, Passive or Neither?

There is an ongoing debate among investing experts as to whether smart beta represents another form of passive index investing or is just another name for active investing. Arguments can be made both ways. Smart beta funds typically track an index or benchmark of some kind and changes to the portfolio are made to rebalance holdings to reflect the benchmark. This is similar to most traditional index products, though the rebalancing if often less frequent. 

Some argue that the nature of the underlying benchmarks is akin to active management. The fees on smart beta ETFs are higher than passive funds but less than active funds. Call it a combination of the two.

The Bottom Line

Your clients may have heard the term smart beta, but likely don’t understand what this means. For financial advisors who are looking to incorporate these products into the portfolios, they design for clients, providing a simple, easy to understand explanation of how they might enhance performance based on the client’s objectives can go a long way towards making clients comfortable with their use.