A type of exchange-traded fund that uses a blend of active and passive investing
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What is a Smart Beta ETF?
Smart beta ETF, a type of exchange-traded fund, that uses a blend of active and passive investing. The fund follows a rule-based approach for selecting investments to be included in a fund portfolio.
A smart beta ETF expands on a traditional ETF, modifying the investments in the fund portfolio based on certain financial metrics. The composition of a fund portfolio is decided based on rules that are established at the time when a fund is launched. Each stock or security in the fund is given a weighting based on the strategy adopted.
Summary
- A smart beta ETF is a fund that follows a rule-based approach to select investments to include in a portfolio.
- A smart beta ETF chooses the companies based on various factors, such as dividend growth, volatility expectations, and total earnings.
- A smart beta ETF combines the features of both active management and passive management, tracking an index and considering different factors for choosing securities from that index.
Strategies of a Smart Beta ETF
A smart beta ETF can choose its securities based on various factors, such as dividend growth of the company, volatility expectations, market capitalization, and total earnings. The most common smart beta ETF strategies are as follows:
1. Equal weightings
The equal weighting strategy involves weighing all the securities equally based on market capitalization, instead of weighting them based on stock price and financial performances.
2. Fundamental weightings
The selection and weightings of the companies are based on financially-driven metrics and fundamentals, such as profits, total earnings, and revenue.
3. Factor-based weightings
The strategy involves weighing the securities based on factors that are separated into levels. Such factors can be growing smaller companies, underpriced valuations, and components of the balance sheet.
4. Low volatility weightings
It is a risk-weighted approach where the focus is on securities with historically low volatility. The fluctuation in the price of a security is measured as volatility. The higher the volatility in the stock, the higher the risk.
Advantages of a Smart Beta ETF
- Increases returns on investments, lowers risks, and maximizes dividends. Smart beta ETF strategies seek to reduce susceptibility to market volatility and outperform the traditional ETFs.
- A smart beta ETF offers a variety of strategies that can help investors to diversify their portfolios.
- Smart beta ETF strategies are outcome-oriented. They can help investors to improve their ability to align the results with their preferences related to cost, risk, etc.
- Although smart beta ETFs may come with higher expense ratios, they are generally less expensive than actively invested funds.
Disadvantages of a Smart Beta ETF
- Since the investing method is relatively new, the trading volumes in the small beta ETFs may be low. It results in low liquidity and does not allow the investors an easy exit of their positions.
- A smart beta ETF purchases the securities from an index that are to be included in the ETF. Hence, trading costs increase. The fees charged for a smart beta ETF may be lower than those of actively invested funds; however, there may not be substantial savings.
- Investors need to consider many variables while investing using a smart beta ETF. Hence, the price of a smart beta ETF may vary from the underlying value of the fund.
Smart Beta ETF: Active and Passive Investing
Active investing involves an investment manager that makes decisions on buying and selling the securities, hoping to outperform an index or benchmark and make profits. A fund is said to be actively managed if the securities are bought and sold as needed, depending on various financial metrics, such as financial ratios and earnings.
A passive fund involves tracking an index such as the S&P 500, where the securities are tracked in the proportion of the market share in that index. For example, if Company X is worth 6% of the total market value of the companies in an index, then the company will be allotted a share of 6% in that index. An ETF replicating that index will then hold 6% of its securities in Company X. A passive fund does not require an investment manager to choose stocks, and hence, comes with lower fees.
A smart beta ETF combines the features of active and passive management. It not only tracks an index similar to a passive fund but also considers various strategies to choose the stocks from that index, similar to an active fund. It implies that a smart beta ETF following the S&P 500 will not replicate all the stocks on the index, rather it will select the stocks based on the weighting strategy.
Additional Resources
CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
