Fundamental or “smart-beta” index-based exchange traded funds are quickly becoming an attractive alternative to traditional market-capitalization funds as investors diversify and become more accustomed to the ETF vehicle.

The new breed of passive smart-beta ETFs select stocks according to fundamental factors like price-to-earnings ratios or volatility, reports Joe Light for the Wall Street Journal.

“A lot of these alternative-weighted approaches really have evolved from active quantitative strategies that were in the investing marketplace 20 years ago,” Joel Dickson, a senior ETF strategist at Vanguard Group, said in the article

In comparison, traditional beta-index ETFs passively reflects established benchmarks, like the S&P 500 (^GSPC), which weights holdings based on market capitalization. Essentially, the biggest stocks have the greatest influence on the portfolio.

Smart-beta ETFs are gaining traction among investors, attracting over $45 billion in assets this year. The new fund category now holds about $263 billion in assets under management, compared to the total $1.63 trillion U.S.-listed ETF market.

Some market observers argue that smart-beta index funds provide investors with an active strategy in an ETF wrapper. However, unlike actively managed funds, smart-beta ETFs have outperformed market capitalization-weighted indices. [‘Smart-Beta’ ETFs Show Higher Returns with Higher Volatility]

According to Research Affiliates, it is a product’s ability to adhere to a set discipline that has helped intelligent indexing outperform market-cap benchmarks. [Smart-Beta ETFs Beating Active Mutual Fund Rivals]

“The trick is that you always sell what’s gone up in price and buy what’s gone down,” Jason Hsu, chief investment officer at Research Affiliates.

Potential investors should also be aware that smart-beta ETF fees are higher than beta-indexed ETFs – smart-beta ETFs have an average annual expense ratio of 0.49%, whereas the cheapest broad market ETF comes with a 0.04% expense ratio. Nevertheless, smart-beta ETFs are still cheaper than stock mutual funds, which have an average expense ratio of 1.4%.

Some of the largest fundamental, smart-beta index ETFs include:

  • PowerShares FTSE RAFI US 1000 (NYSEArca: PRF): up 29.1% year-to-date
  • First Trust Health Care AlphaDEX Fund (NYSEArca: FXH): up 38.9% year-to-date
  • First Trust Consumer Discretionary AlphaDEX Fund (NYSEArca: FXD): up 35.7% year-to-date
  • First Trust Consumer Staples AlphaDEX Fund (NYSEArca: FXG): up 35.9% year-to-date
  • PowerShares FTSE RAFI 1500 Sm-Mid (NYSEArca: PRFZ): up 33.7% year-to-date

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

Max Chen contributed to this article.

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