How to Utilize Smart-Beta ETFs in Your Portfolio

The new batch of strategic- or smart-beta index-based exchange traded funds help diversify investment portfolios beyond traditional cap-weighted holdings, but long-term investors should be prepared to experience cyclical trends.

“It is again very important to understand what the behavior of these various strategies is over time and that they can go through extended periods of both out-performance and under-performance,” David Koenig, Investment Strategist for Russell Indexes, said in a Morningstar article.

While academic research has shown that some of these smart-beta styles can outperform over the long-term, investors should still manage their expectations.

“So with any of these smart-beta factor-based strategies, they do represent significant tilts toward a specific factor, and while over a long period of time a factor, such as low volatility or value, may show significant outperformance, there can be extended periods of underperformance, as well,” Koenig added.

However, investors can smooth out their returns and diminish overall volatility by combining the strategies within their investment portfolios as a way to level out periods of outperformance or underperformance.

People can combine factor-based ETFs with cap-weighted index funds to benefit from diversification among index-based strategies as well. For instance, the RevenueShares Large Cap Fund (NYSEArca: RWL), which is comprised of S&P 500 stocks but weights holdings by revenue, has increased 6.6% year-to-date while the S&P 500 Index gained 7.6% this year. Over the past five-years, RWL returned an average annualized 21.9%, whereas the S&P 500 returned 20.0%.