The so-called smart-beta indexing methodology is gaining traction among the exchange traded fund investment community. But what exactly are smart-beta index ETFs?

Smart-beta ETFs are loosely defined as ETFs that employ an active investment strategy based on a broad index. These types of funds track a rules-based index that screen for specific investment risk factors, instead of traditional market capitalization-weighted indices. [WisdomTree: What Is Smart Beta Anyway?]

Aniket Ullal, founder of First Bridge Data, for Seeking Alpha breaks down smart-beta ETFs into three key components: indexing, risk factors and exclusion of cap-weighted size, style and sectors.

The indexing component is pretty straightforward as it excludes all actively managed ETFs that do not passively follow an underlying index. The risk factors refer to definable screens that an index would consider, such as low volatility and momentum, among others. The exclusion of cap weighted size, styles and sectors identifies strategies that investors previously had no access to via index-based ETF offerings.

While the term “smart beta” has a catchy ring, investors should not read too deeply into it or infer that these types of ETFs are “smarter” than traditional market-cap weighted broad market ETFs. The alternative indexing methodology will perform differently during varying market cycles.

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