ETF Trends
ETF Trends

Smart-beta exchange traded funds that track customized indices have grown in popularity as an alternative to traditional market-capitalization-weighted funds. With more taking an interest in the strategies, it is important to understand how they differ from other investment tools.

For starters, Ben Johnson, global director of ETF research at Morningstar, points out that these strategic- or smart-beta ETFs represent a hybrid of active and passive styles.

“It sits in this middle ground between active and passive,” Johnson said. “Like active funds, strategic beta exchange-traded products and mutual funds track indexes that have an active bet embedded in them from the moment that their methodology is locked in. Now, like their passive parent, strategic beta benchmarks are transparent. They are investable in a rules-based manner, and they are investable at a very low cost.”

For instance, Johnson points to a suitable long-term, core-equity smart-beta ETF play, the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF). PRF marries a unique active disciple with an passive investment style. Specifically, the ETF’s underlying index selects and weights companies based on fundamental factors, such as sales, cash flow, dividends and book value, whereas traditional beta-index ETFs weight stocks based on market capitalization. The benchmark automates all the active stock picking based on the predetermined strategy and the ETF passively reflects the underlying index.

These strategic-beta strategies are growing in popularity. U.S.-listed smart-beta ETFs have accumulated in excess of $400 billion in assets under management, compared to the overall $2.16 trillion in all U.S.-listed ETFs. [Business is Booming for Smart Beta ETFs]

Currently, the majority of smart-beta ETF investments are in dividend-oriented strategies, which is unsurprising as investors are using these readily available dividend ETFs to easily generate income in a low-yield environment. For example, the Schwab US Dividend Equity ETF (NYSEArca: SCHD) is the cheapest way to gain exposure to a group of high-quality dividend-paying U.S. stocks.

Moreover, institutions are looking at smart-beta ETFs for more targeted factor exposure in an attempt to manage risk exposure. For instance, the iShares MSCI USA Value Weighted Index Fund (NYSEArca: VLUE) and the iShares MSCI USA Momentum Factor ETF (NYSEArca: MTUM) are two of the four factor ETFs created by BlackRock’s iShares unit in 2013 in conjunction with the Arizona State Retirement System.

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