What Are ‘Smart-Beta,’ Factor-Based Index ETFs?

December 9th at 2:00pm by Tom Lydon

The new breed of “smart-beta” exchange traded funds has quickly expanded as investors use alternative investment tools to diversify away from traditional market capitalization-weighted indices.

Smart-beta ETFs are based on factors that reconfigure standard market-cap indices into smart-beta indices, including equal weight, fundamental, value, momentum, quality and minimum volatility, among others, in what can be aptly called “factor indices,” writes Deborah Fuhr, Managing Partner at ETFGI, for Financial News. [‘Smart-Beta’ ETFs Provide Active Strategies in a Passive Wrapper]

The term “beta” refers to non-diversifiable risks of a market and expresses the volatility of returns compared to a large benchmark, like the S&P 500. It has a default value of 1.0.

Academic research has also found that alternative indexing methodologies, beyond traditional market-cap, have generated better returns with lower risk over long periods. Consequently, money managers and sponsors have been quick to adopt factor indices as a way to avoid the flaws in market-cap indices and shift away from inconsistent performance in active funds. [Some Smart Beta ETFs Draw Praise]

However, potential investors should be aware that factor index-based strategies tend to create biases, or a tilt toward certain stocks.

“Smart indices are built using various factors that will create biases, of which the investor must be aware,” Fuhr said in the article. “Equal-weight indices have a small-cap bias while fundamental indices have a value bias. These biases are the reasons that the indices perform differently than market cap.”

Additionally, investors should also understand that these strategies may also experience periods of underperformance over the short-term, compared to market-cap indices.

According to State Street Global Advisors, there was $142 billion invested in factor based-strategies at the end of the first quarter of 2013. Factor-based strategies have attracted $81.6 billion over the past three years, with ETFs accounting for $66.2 billion. Optimistic projections point to these strategies growing to 30% of passive equities, or about $6 trillion, in the next five years.

For more information on ETF indices, visit our indexing category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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