Given the large number of smart-beta strategies now available, investors should understand how the ETFs’ underlying indices are constructed and the specific characteristics that they exhibit. For instance, RAFI equity strategies weight companies based on fundamental measures, such as adjusted sales, cash flow, dividends and buybacks.
The PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), which tracks a Research Affiliates index, is one of the longest running smart beta ETFs on the market and will hit its 10th anniversary in December.
Once an ETF methodology is understood, it is up to the investor to determine where a smart-beta ETF fits in with an overall investment portfolio. Most broad smart-beta ETFs, like RAFI strategies, may help investors generate attractive long-term, risk-adjusted returns. Additionally, the amount exposure would depend on one’s risk tolerance as some of the holdings may be contrarian to an investor’s overall outlook. [Index ETF Investors Should Better Understand Their Benchmarks]
Potential investors should also understand that these strategies work well under a long-term horizon and short-term volatility may cause under or outperformance.
“Our own Jason Hsu and John West have written separately on the importance of not only identifying outperforming strategies but keeping them during the inevitable periods of underperformance,” Arnott said. “No strategy works all the time; if we chase what’s worked recently and drop whatever has been disappointing, we can undo the benefit of all our hard work identifying superior strategies.”
For more information on smart beta strategies, visit our smart beta category.
Max Chen contributed to this article.