Many investment innovations have been meet with skepticism, but exchange traded funds (ETFs) that track smart-beta or alternative index-based strategies have quickly caught investors’ attention.
Contributing to the rapid growth, smart beta ETFs have helped investors capitalize on actively managed investment styles at a fraction of the cost.
“Strategic beta, unlike most innovations, demands less from portfolio managers, not more,” writes John Rekenthaler, V.P. of research at Morningstar. “As a result, it charges less. There aren’t many investment principles sounder than the statement that expecting less and paying less yields better results than expecting more and paying more.”
Related: Liquidity For Smart Beta ETFs Improves
Smart- or strategic-beta ETFs passively track an underlying benchmark index. However, the underlying indices are not your run-of-the-mill, cap-weighted benchmarks that copy existing markets. These smart-beta indices cherry pick stocks based on specific factors, which give them a kind of active component. For instance, some of the more popular factors or investment styles in smart beta ETFs we are seeing today include low-volatility, value and dividends.
For example, the Vanguard Dividend Appreciation ETF (NYSEArca: VIG), iShares Select Dividend ETF (NYSEArca: DVY) and Vanguard High Dividend Yield ETF (NYSEArca: VYM) are some popular dividend-oriented ETF strategies. Moreover, investors have been looking at low-vol strategies, like the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) and PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), this year.
[related_stories]“In choosing to hold only a market segment rather than the whole, strategic-beta funds make active decisions,” Rekenthaler said. “And active decisions, by definition, lead to higher expenses and more potential headaches.”
However, while the smart beta may be active in nature, the strategy is implemented through a passive index-based ETF, which helps cut down costs. There are 574 enhanced index-based U.S.-listed ETFs with an average 0.58% expense ratio, according to XTF data.
Related: Smart-Beta ETFs that Capitalize on the Knowledge Effect
“Silence the noise, and you’ll see that most winning active managers succeed for only a few reasons – factors, if you will,” Rekenthaler said. “So why not buy those factors and skip the rest?”
An active portfolio manager may conduct research and analysis on a group of securities and screen for specific qualities. Investors have traditionally paid a premium for the added effort. However, this active style can be easily replicated through a cheaper mechanical model or a passive smart-beta ETF competitor.
For more news and strategy on the Smart Beta market, visit our Smart Beta category.