ETF Trends
ETF Trends

Investors are piling into so-called enhanced, fundamental, factor-based, smart-beta index exchange traded funds that have been outperforming traditional market-captitalization weighted ETFs. However, investors should not blindly jump into these strategies before they fully understand how the products work.

The new breed of smart-beta ETFs follow customized benchmark indices that weight component holdings based on factors, like dividends or sales. Advocates have pointed out that some methodologies have generated returns that beat traditional benchmarks, like the S&P 500, over the past five-years, reports Alexis Xydias for Bloomberg.

“It feels like an inflection point for these strategies,” Daniel Pytlik, a manager at Bank Julius Baer & Co., said in the article. “There seems to have been an acceleration of both demand for and supply of smart beta. Lots of things are going on in terms of the debate around the topic.”

According to Bloomberg data, smart-beta ETFs attracted $43 billion last year and now hold $156 billion in assets under management as of the end of February.

However, due to the specialized nature of the underlying indices, smart-beta ETFs issuer higher annual fees than the traditional beta-index ETF.

Additionally, smart-beta ETFs tend to lean toward mid- and small-sized companies, which tend to experience greater swings during a risk-off environment, but the tilt helped the ETFs outperform during market rallies, as witnessed last year. [What to Look for in Smart Beta ETFs]

“It all looks and sounds good on paper, but the guarantee is that it is going to cost you more money, you are going to take more risk, and you can underperform for a long time,” Rick Ferri, founder of Portfolio Solutions LLC, said in the article.

In comparison, traditional benchmarks, like the S&P 500, are size-weighted, so large companies like Apple (NasdaqGS: AAPL) and Exxon Mobile (NYSE: XOM) have a heavy influence on the direction of the index. [Smart Beta Boom]

“When you dig down, smart beta adds value because they don’t weigh on price,” Rob Arnott, founder of Research Affiliates, said in the article. “They don’t reward a company just for having a higher price, and that is where the central source of value added for every segment of smart beta space lies.”

The value added can translate to better portfolio returns over long periods. According to Towers Watson & Co, smart-beta strategies that select stocks based on small daily prices swings, utilize a diversification component, track companies based on fundamentals and equally weight holdings have outperformed capitalization-weighted indices over the past five decades. [Indexology: Incorporating Smart Beta Strategies in Asset Allocation]

For more information on ETF flows, visit our ETF performance reports 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.