By Rusty Vanneman, CLS Investments

At CLS Investments, we are heavy users of smart beta ETFs, so understanding smart beta is key to understanding CLS portfolios.

Smart beta ETFs have become increasingly popular, but they are not always easy to explain. Though adoption rates by investors are quickly increasing, surveys show that the leading reason adoption rates aren’t even higher is because investors are still trying to understand exactly what smart beta ETFs are and what they’re used for.

Smart beta (factor-based) ETFs are, technically, any ETF that is passively managed and weights its securities based on something other than market capitalization, like revenues or earnings. Put simply, smart beta ETFs capture the essence of active management at a fraction of the cost.

Why Smart Beta Wins

They capture the essence of active management because the factors that construct smart beta ETFs are typically the same fundamental screens many money managers use when building portfolios.

All else being equal, lower cost always wins. Thus, smart beta is attractive because many investors use active management to achieve superior, risk-adjusted performance, but smart beta strategies allow them to do so at a far lower cost.

While the average actively managed mutual fund has an expense ratio of more than 1% per year, the average smart beta ETF has an expense ratio of approximately 0.3-0.35%, or about a third of the cost. That’s a good head start for better performance.

Better yet, factor investing – particularly when using the five global equity factors we focus on: quality, value, low volatility, momentum and small-caps – has provided an average annual excess return (above the overall market) of more than 2% a year for the last 20+ years.

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