Smart beta exchange traded funds have quickly grown in popularity. As more investors incorporate these strategies into their investment portfolios, it is important look under the hood and differentiate one smart beta ETF from another.
Like most other ETFs, smart beta ETFs are passive in nature, passively reflecting the performance of an underlying index. However, unlike traditional beta-index funds that adhere to market capitalization weighting methodologies, smart beta ETFs follow rules-based indices that screen for specific factors, similar to how active managers pick and choose their own securities.
Consequently, potential investors should take the time to consider the differences between prospective smart beta ETF investments.
For starters, there are a number of smart beta ETFs that only screen for a single investment factor. For example, the iShares Russell 1000 Growth ETF (NYSEArca: IWF) and iShares Russell 1000 Value ETF (NYSEArca: IWD) may be considered the simplest form of smart beta as they specifically screen for growth or value stocks, respectively.
As fund providers expand their ETF offerings, some have come out with other single-factor strategies that go beyond traditional market styles. For example, the PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV) has become a popular way to access S&P 500 companies that exhibit low volatility in an attempt to enhance returns and diminish risk exposure. More recent factor-based ETF strategies include those like the Oppenheimer Large Cap Revenue ETF (NYSEArca: RWL), which weights components based revenue generated.
Going beyond single factor picks, money managers have also come out with a number of multi-factor strategies that combine academically and historically proven factors, like value, quality, yield, company size and low volatility, to help investors generate improved risk-adjusted returns. For instance, the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), which has been around since December 19, 2005, ranks among the longest running multi-factor, smart-beta ETFs in the U.S. markets. PRF tracks 1,000 U.S. stocks that show the highest fundamental strength based on the RAFI fundamental indexing methodology, which screens for sales, book value, cash flow and dividends.
ETF sponsors are not just limited to a handful of factors when combining them into a smart-beta ETF. For instance, the recently launched IQ Chaikin U.S. Small Cap ETF (NasdaqGM: CSML) includes a 20-multi-factor model that screens for value, growth, technical and sentiment factors, such as price-to-book value, return-on-equity, free cash flow, price trends, relative strength, volume trend, earnings growth, earnings trends, projected price/earnings ratio, insider activity, short interest and earnings estimate trends. The gauge will identify each security’s ability to outperform market-weighted products and active strategies.
As more investors consider smart beta strategies in an increasingly expanding ETF universe, it is important to take the time to carefully consider the underlying factors that help the smart beta ETF do what it promises to do. This way investors will better manage expectations and help grow their portfolios in the time-frame they are comfortable with.