The smart beta ETF segment is quickly expanding, with money managers rolling out increasingly sophisticated strategies that incorporate a number of investment styles.
However, investors should keep in mind that the best smart beta ETF investment is often the one that fits well with one’s own objectives.
“Smart beta doesn’t have to be complex. While some non-traditional index approaches rely on more involved quantitative modelling, some popular smart beta index construction approaches follow simple, intuitive methodologies,” according to a FTSE Russell note.
Passive investments now make up for $6 trillion of assets globally and 29% of assets under management, according to a 2017 Moody’s Investor Services report.
Smart beta is a subset of passive indices that depart from the standard market capitalization weighting methodology to achieve a particular objective, like generating excess returns, mitigating volatility or improving diversification. Nevertheless, smart beta, like traditional beta indexing, are constructed according to a consistent set of rules and are transparent.
Investors may notice a flurry of new smart beta index ETFs that incorporate multiple factors to generate improved risk-adjusted returns. However, some of the original smart beta indexing methodologies may still warrant some attention.
“Equal-weighted and fundamental indexes are two such approaches: they use a straightforward construction methodology in order to address potential concentration or valuation concerns inherent in capitalization-weighted indexes,” FTSE Russell said.
Equal weight index constituents, like the name suggests, receive an equal weight, and they are rebalanced regularly to keep components in line. The equal weight methodology helps address concerns about potential concentration risks in traditional capitalization-weighted indices where the largest and most popularly traded companies account for outsized exposures within the index.
Fundamental indices incorporate specific screens when selecting stocks or measures companies based on fundamental measures, such as sales, operating cash flow, dividends and book value – factors that have traditionally been associated with value. The approach favors securities whose prices have diminished while underweighting those whose prices have increased.
“When choosing between standard, capitalization-weighted indexes and smart beta indexes, market participants often bear in mind questions of simplicity and transparency, cost, liquidity, capacity and governance. Index users should also evaluate smart beta in the context of the original objectives, such as the generation of excess index returns, the mitigation of volatility, or diversification. This information is as readily available as it is for capitalization-weighted indexes and should not be an obstacle to considering smart beta alongside more traditional index options,” according to FTSE Russell.
For more information on alternative index-based strategies, visit our smart beta category.