A growing number of alternative, smart beta index based exchange traded funds have become a popular investment tool to gain market exposure without being exposed to potential risks associated with traditional market capitalization-weighted indices.
According to PowerShares, smart beta ETFs refer to a group of investments that share similar properties as passive and actively managed funds. The smart beta ETFs may employ a actively managed styles, but the ETFs still track a underlying index, albeit one that follows a rules-based methodology.
For instance, one of the ETFs that kick-started the smart beta movement is the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), which celebrates its tenth anniversary in December. The RAFI strategy weights stocks based on fundamental measures, including book value, cash flow, sales and dividends, as opposed to the traditional market-capitalization methodology, which would overweight the best performing stocks. [Enhanced ETF Strategies with Enhanced Indexing Methodologies]
Another popular ETF during more volatile market conditions is the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), which focuses on the 100 least volatile stocks on the S&P 500. [ETFs to Play the Market During More Volatile Conditions]
Additionally, the smart beta ETFs may also outperform the benchmark index while potentially reducing risk through added diversification.
For example, market cap-weighted indices may expose investors to overbought stocks since the largest components are those that have outperformed or grown to be the biggest around.
Looking at the tech sector, technology companies quickly rose during the dotcom bubble and made up a significant portion of the S&P 500. While the market cap-weighted index may have helped investors ride the surge, the overweight position in tech also exposed investors to the bursting dotcom bubble.