As the smart-beta segment becomes a significant force in the exchange traded fund space, ETF investors should understand how the indexing structure works and the potential benefits of utilizing the investment strategy.

In a recent Charles Schwab note, Anthony B. Davidow, vice president for alternative beta and asset allocation strategist at Schwab Center for Financial Research, pointed out that there is nearly $400 billion in assets in smart- or strategic-beta ETFs.

Leading the space of smart-beta funds, Research Affiliates Fundamental Index strategies are home to roughly $140 billion in invested assets.

Rob Arnott, chairman and co-founder of Research Affiliates, argues that the rapid growth is attributed to investors’ desires for alternative indexing methodologies that did not follow traditional market-capitalization weights.

“It made no sense that an investor in a cap-weighted index would inherently have his greatest exposure to a company precisely when it was most expensive,” Arnott told Schwab. “That entire construct runs completely counter to the basic axiom of buy low, sell high.”

Consequently, through back testing, Research Affiliates found that rebalancing away from market-cap generated excess returns, notably greater excess returns in U.S. large-caps and even greater returns in less efficient markets like small-caps and emerging markets.

“Rebalancing works!” Arnott added. “It works across time periods. It works across geographies. Routinely selling the most loved companies (“popular” stocks) and buying the most loathed (“underappreciated” stocks) generates excess returns over a cap-weighted index that assigns company weights based solely on popularity.”

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