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What is a 'Smart Beta ETF'

A smart Beta ETF is a type of exchange-traded fund that uses alternative index construction rules instead of the typical cap-weighted index strategy, in a transparent way. It takes into account factors such as size, value and volatility. It utilizes both passive and active methods of investing – passive, because it follows an index, but active, because it considers alternative factors. Smart Beta ETFs are ideal for investors hoping to maximize their income and returns and minimize risk.

BREAKING DOWN 'Smart Beta ETF'

Smart Beta ETFs use a variety of smart beta strategies to maximize returns, and they focus on areas of the market that can be exploited. The most common type, a dividend-oriented ETF, screens holdings for dividend growth. Low-volatility and high-beta ETFs focus more on risk reduction. Risk-weighted approaches take into account future volatility predictions and often take historical performance into account to make this estimate. There are four main types of Smart Beta ETF strategies:

  • Equally weighted indexes: Instead of weighting standard indexes based more on price and capitalization, this strategy takes all factors equally into account.
  • Fundamentally weighted indexes: Companies are selected and weighted by such factors as total earnings.
  • Factor-based indexes: Using this method, stocks are weighted, but this method can also separate factors into tiers and equally weigh each factor in a given tier.
  • Low volatility indexes: This method focuses on indexes with low volatility, and indexes are weighted based on their historic volatility.

Benefits Associated With Smart Beta ETFs

In general, Smart Beta ETFs are designed to increase portfolio returns, maximize dividends and lower portfolio risks.

One of the arguments for Smart Beta strategies such as equal weighted indexing is that they remove the emphasis on the stocks in the index with largest market cap weightings. When these stocks 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 cheaper than most actively managed funds.

Risks Associated With Smart Beta ETFs

Smart Beta ETFs are still a relatively new method of investing and they are often not based on actual data, which makes it hard to determine in advance if they will be effective with large investments. Additionally, trading costs can be higher in order to re-establish the original index weight. Some risks associated with Smart Beta ETFs include:

  • False Alpha: Smart beta strategies come with new risks not associated with traditional strategies, which might undercut the fund's earnings.
  • Crowding: Once a strategy is overused, it no longer performs as well and can even underperform in relation to traditional indexes.
  • Tracking error: Smart Beta ETFs tend to underperform on traditional indexes, such as the S&P 500, since they need to constantly readjust indexes.
  • Trading issues: Smart Beta ETF trading can be more difficult than trading with traditional indexes, as Smart Beta ETF prices can vary from the fund's underlying value.
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