Strategic- or smart-beta indices are the hot strategy in the exchange traded fund industry. Before dabbling in one of these relatively new ETF investment tools, investors should do their due diligence to better understand the products.
For starters, Susan Dziubinski, Director of Content with Morningstar, defines the new breed of strategic ETFs as an active-passive hybrid, or index-based funds that make active bets. These smart-beta ETFs try to improve the risk or return characteristics of traditional market-capitalization-weighted indices, such as the S&P 500.
The smart-beta index-based ETFs try to boost returns or diminish risk by focusing on more or more factors, such as value, growth or volatility, among others. As a result, investors will have to look deeper into a smart-beta ETF’s strategy to understand how the fund works. [Look Before Leaping Into Smart-Beta ETFs]
The alternative index-based strategy has been around longer than most might believe. For instance, the iShares Russell 1000 Growth ETF (NYSEArca: IWF) and iShares Russell 1000 Value ETF (NYSEArca: IWD) may arguably be among the first smart-beta ETFs to track customized indices other than a market-cap-weighted methodology, debuting back in 2000.
Although, more defined smart-beta ETFs, such as the fundamental index-based the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), are nearing a 10-year anniversary.
As the ETF industry grows, strategic-beta funds are becoming increasingly complex. During the nascent stages of the alternative index-based ETF growth, investors would pick from mores straightforward styles, such as value, growth, dividends, asset category and even equal-weight methodologies. However, as the industry matures, we are seeing more factor-based styles from RAFI, Dorsey Wright, WisdomTree and First Trust’s AlphaDEX, among others, that mix multiple factors into a single investment offering. Consequently, it is up to investors to know what they are getting themselves into.
“Investors’ due-diligence processes for these funds need to be every bit as rigorous as those they would undertake in scrutinizing active managers,” according to Morningstar.
When shopping around, investors may notice that some factors are more “proven” than others, such as value investments.
“Some betas–or factors–are well grounded in economic and/or behavioral patterns,” Morningstar director John Rekenthaler said. “That is, they are associated with real risks, which is why they offer real and ongoing higher returns.”
Moreover, investors may have to be patient as some factor-based index strategies shine when held with a long-term investment horizon. [Low-Volitility ETFs Can Still See Swings in Short Timeframes]
Lastly, investors should still mind the fees. While strategic-beta funds typically have similar costs to the overall ETF industry, some may offer cheaper fees than others. There are currently about 1100 passively managed U.S.-listed ETFs with an average 0.56% expense ratio, and some of the cheapest index-based ETFs have a 0.04% expense ratio, according to XTF data. Meanwhile, the 461 U.S.-listed enhanced ETFs on the market have a slightly higher 0.62% average expense ratio. [Costs, Provider Know-How Matter with Smart-Beta ETFs]
For more information on smart-beta index funds, visit our smart beta 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.