Smart-Beta ETF Buying Guide

Investors are increasingly adopting smart- or strategic-beta exchange traded funds as an alternative to traditional market capitalization-weighted index funds. With the multitude of options available, investors should take the time to compare smart-beta ETF options.

For starters, strategic-beta exchange traded products that invest in U.S. stocks and have a 0.70% expense ratio or more should be scrutinized, writes Ben Johnson, director of global ETF research at Morningstar.

Of the 124 large-cap U.S. equity strategic-beta ETFs, about two thirds charge a 0.40% expense ratio or less, or 10 times the cost of cheapest plain-vanilla U.S. stock ETF come but much still cheaper than the 0.93% median cost for large-cap no-load mutual funds.

Smart-beta ETFs are considered a mix of both passive index-based offerings and actively managed styles. Specifically, the enhanced, factor-based, smart-beta ETFs will passively track an underlying index. However, the underlying index implements actively managed strategies, such as focusing on low-volatility, momentum and value, among others. [Where Smart-Beta ETFs Fall On The Passive/Active Spectrum]

“Like their active parent, they deliberately stray from the “market” portfolio with the intent of improving relative returns, decreasing or increasing relative risk, or some combination of the two,” Johnson said. “As is the case with selecting active managers, investors must assess these products’ strategies to ensure that they are sensible and efficient and have ample capacity.”

Due to the different factor-based indexing methodologies, the nuanced differences in index construction can create different performance profiles among similar strategies. Consequently, investors should take the time to understand how efficiently a smart-beta fund’s underlying benchmark is at following targeted factors and whether other costs may be holding back performance.

Johnson also advises investors to consider capacity of factor bets. The staying power of any factor is based on there being someone willing to take the opposite side of a factor bet. For instance, for value to produce excess returns, there must be a number of people who disregard value. Currently, Johnson sees capacity in fundamental factors, such as value and momentum, and in broad markets, like U.S. stocks and international stocks.