Smart beta strategies have generated significant visibility, and many exchange-traded funds (ETFs) leveraging such approaches have emerged. While investors have many options because of the proliferation of such funds, they may not understand the true costs of smart beta ETFs.

Smart Beta

It is important to comprehend what smart beta actually means. While there are different definitions of the term, the ETFs that harness such strategies usually track some underlying index, but are different in that they do not rely solely on weighing the market capitalization of the different components. Instead, smart beta ETFs harness factor investing, an approach that utilizes the many independent factors researchers have used to explain the historical price movements of assets and portfolios.

Researchers have singled out as many as 300 such variables. By incorporating these factors into a rules-based approach, smart beta ETFs attempt to produce stronger risk-adjusted returns than their passively managed counterparts. While some of these smart beta funds attempt to generate higher returns than their underlying benchmarks, others have the objective of lowering risk. While this may sound promising, there are both guaranteed and potential costs that come along with smart beta ETFs.

Generating Alpha

While a smart beta ETF designed to produce stronger returns than its normal beta counterpart may meet this objective while markets are trending higher, the same factors that helped produce this outperformance may cause the smart beta fund to underperform when the markets decline. In addition, this underperformance could be greater than the outperformance generated when the markets rose.

High Fees

On average, smart beta ETFs carry higher fees than ETFs based on more traditional market capitalization-weighted indexes. In some cases, the fees charged by smart beta funds are only slightly higher, such as with funds providing exposure to emerging markets. In others, the fees for smart beta funds can be substantially higher, such as those associated with U.S. large-cap stocks. Smart beta ETFs using the Standard & Poor’s 500 Index have an average total expense ratio three times higher than passively managed ETFs that use the same underlying index.

Tracking Error

The tracking error of smart beta ETFs can be far higher than that of more traditional ETFs. While running a market-capitalization-weighted ETF is relatively straightforward, smart beta strategies frequently require regular rebalancing and adjustment. A perfect way to illustrate this is the different tracking errors of iShares S&P 500 ETF (NYSEARCA: IVV), which relies on market capitalization weighting, and iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV), a smart beta fund.

IVV follows the S&P 500 index very closely, with the only difference generally being the expense ratio. Alternatively, USMV has had a more difficult time replicating the results of its underlying index, trailing it by almost 40 basis points at times.


One factor that can be a problem for smart beta ETFs is the over-investment they may draw because of their visibility. While funds that use smart beta strategies can outperform their more traditional counterparts, this outperformance gap could dwindle as such funds draw more investment. If an ETF uses a smart beta strategy to exploit a market inefficiency and generate robust returns, investors might flock to the fund that uses this approach, which could in turn eliminate the inefficiency, and therefore the opportunity.

Implementation Challenges

Companies that manage smart beta ETFs might run into challenges implementing their strategies. If the fund expects to generate a small alpha, the associated costs of running the investment vehicle, including taxes, fees and implementation, can easily surpass this outperformance.

Summing It Up

Amid all this information, investors should keep in mind that while smart beta ETFs do offer significant potential, they also come along with numerous costs and potential pitfalls. Investors considering these funds might benefit from conducting the needed due diligence and/or consulting an investment advisor.

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