When It Comes to Smart Beta ETFs, There Is No Right or Wrong

As more investors consider alternative investment strategies in an extended bull market environment where some of the largest companies may look pricey, many are searching through smart beta exchange traded funds for the right fit.

The so-called smart beta, enhanced, strategic beta, alternative or factor-based index ETFs all follow a similar theme where the underlying indices eschew conventional market capitalization-weighted methodologies for customized or rules-based allocations, tracking a range of strategies from equally weighting stocks to identifying momentum across different corners of the market, among many others. What ties the theme together is the ability to add exposure to specific factors found in traditionally active managed funds.

“As with any investment strategy, understanding how it fits in a portfolio is vital,” Salvatore J. Bruno, Chief Investment Officer and Managing Director at IndexIQ, said in a research note. “With smart beta, that means knowing the factor or factors that are optimized in an ETF’s underlying index, and understanding how an ETF built on these factors will interact with other elements in an investment strategy. Does an ETF built on bond market momentum replace or augment other fixed-income holdings? How will a low-volatility position impact overall returns across a market cycle?”

This becomes increasingly more important as a growing number of investors seek out smart beta ETF options. Las year, single- and multi-factor ETFs saw over $8 billion in net inflows globally, according to Pensions & Investments. Total assets in these types of funds reached almost $560 billion globally by the end of February 2017, with $500 billion in the U.S. alone, according to ETFGI data.

It isn’t just the mom and pop investor looking for smart beta ETFs. The strategies are finding their way into more institutional portfolios. About 65% of U.S. pension funds, including corporate pensions, public pensions, foundations and endowments surveyed by Greenwich Associates are buying and holding ETFs for two years or longer. Looking overseas, European institutions are exhibiting an increasing appetite for factor-based ETFs.