Strategic- or smart-beta exchange traded funds provide exposure to an alternative indexing methodology that employs actively managed styles in a passive wrapper to generate greater returns while maintaining broad exposure to the equities market.

On the recent webcast, Innovations in Indexing: Constructing Global Portfolios with Smart Beta ETFs, Luciano Siracusano, Chief Investment Strategist and Head of Sales at WisdomTree, explains how smart-beta strategies are an amalgamation of traditional market capitalization-weighted indexing and alpha-generating actively managed styles.

“Like traditional, market capitalization-weighted approaches, smart beta is rules-based,” Siracusano said. “However, the difference is that the rules of a smart beta approach are designed to attempt to capture potential return premia.”

Siracusano explains that traditional cap-weighted indices do not have any built-in sensitivity to changes in relative value. The indices can potentially overweight overvalued companies or underweight undervalued firms. Consequently, iif prices will eventually move toward fair value, an market cap-weighted index fund may not be an efficient approach to the market.

“WisdomTree believes that re-weighting equity markets based on fundamentals like dividends or earnings can help to produce both better total and risk-adjusted returns over time,” Siracusano said. “We are simply of the belief that a sensitivity to constituent fundamentals and a relative value rebalance have the potential to mitigate the risk of generating exposure to overvalued firms.”

For example, the WisdomTree Total Earnings Fund ETF (NYSEArca: EXT) follows broad U.S. companies that have generated positive cumulative earnings over the past four fiscal quarters prior and then weights holdings by greatest earnings.

Additionally, investors can break down the U.S. markets into separate categories with the WisdomTree Earnings 500 Fund (NYSEArca: EPS), WisdomTree MidCap Earnings Fund (NYSEArca: EZM) and WisdomTree SmallCap Earnings Fund (NYSEArca: EES).

Consequently, the earnings-weighting methodology tilts toward more attractively valued stocks, which make these earnings ETFs show lower price-to-earnings ratios than their respective market cap-weighted counterparts.