As the exchange traded fund universe expands into enhanced, “smart-beta” indexing strategies, financial advisors are spoiled for choice. Still, it is important to pause and take a moment to understand what you’re getting yourself into.
“Having so many choices is a good problem to have, but it is important to understand the differences among them to construct an investment portfolio that suits its intended purpose,” Dan Waldron, senior vice president and ETF strategist at First Trust Portfolios LP, said on InvestmentNews. “It may be helpful to put all ETFs into two broad categories: beta and alpha.”
Traditional beta index-based ETFs passively track a specific market. Due to the favorable tax treatment, efficiency, liquidity, transparency and flexibility associated with the ETF structure, the industry has evolved to include alpha-pursing products, including the new breed of enhanced index ETFs. [Enhanced Indexing]
These smart-beta ETFs also passively track a market index, but the indices utilize alternative methods to weight holdings, instead of the traditional market capitalization.
“Traditional beta strategies mitigate a degree of individual security risk through diversification but, because they are market capitalization-weighted, the largest companies in the index can represent a significant weighting and create unwanted risk,” Waldron added. “The non-traditional beta and alpha approaches attempt to limit exposure to the largest stocks and increase exposure to others in an attempt to provide better returns.”
Among the nontraditional enhanced, smart-beta index ETFs, Waldron breaks it down further into nontraditional beta and nontraditional alpha methodologies. Nontraditional beta indices typically track the same stocks as the benchmark index, except constituents use al alternative measure of size to weight. Nontraditional alpha is explained as an ETF that track indices designed to seek risk-adjusted excess returns. [Jaffe Weighs in on Schwab Fundamental ETFs]
“These indexes mimic the approach and behavior of active managers in many ways by applying certain rules relating to when to buy and when to sell,” Waldron said.
“Stocks with a better price-to-cash-flow valuation historically outperformed those with a worse price-to-cash-flow valuation,” he added. “The fact is, fundamental valuation matters.”
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.