The ETF industry has traditionally been dominated by products
based on market capitalization weighted indexes that are designed
to represent the market or a particular segment of the
market. Market cap weighted indexes work great for
investors who believe in market efficiency. They provide a
low-cost, convenient and transparent way of replicating market
3 Niche ETFs Crushing the Market
On the other hand, some investors who believe that it is possible
to beat the market by superior stock selection opt to invest
through active managers. However, returns generated by actively
managed funds do not always justify the higher costs associated
Many retail investors are not aware about another class of funds
that adopt the "middle path" of tracking non-cap weighted
strategies--popularly known as "Smart Beta". Many analysts do not
agree with the word "Smart" and prefer to call them "Alternative"
or "Advanced" beta strategies. (Read:
3 Growth ETFs for a Continued Small Cap Surge
What is Smart Beta?
These indexes attempt to select stocks that have better chances
of risk-return performance, based on certain fundamental
characteristics or a combination of such characteristics. So in
simpler words, it is like starting with the same set of
ingredients but adding a twist to the traditional recipe by
changing the proportion of ingredients to enhance the taste and
flavor of the dish.
While not so popular with retail investors yet, these strategies
have already become very popular with institutional investors.
, "Smart Beta" products may attract about one-third of global
institutional equity allocations by 2018. (Read:
3 ETF Winners from the No-Taper shocker
Do Smart Beta Strategies Deliver Smart Results?
Increasing interest in these strategies is a result of their
better performance compared with cap-weighted funds, usually at a
much lower-cost than actively managed funds.
on 13 alternative indexes for the period from 1968 to 2011 show
that while the market-cap index generated a 9.4% annualized
return, alternative indexes delivered between 9.8% and 11.4%
annualized return. (Read:
Beat Hedge Funds with these ETFs
While this space offers a number of choices to investors,
including simplest equal-weighting, fundamental weighting and
volatility/momentum based weighting methodologies, not all these
strategies have been able to deliver superior results. Below we
have highlighted three options that have delivered better results
than their market-cap weighted counterparts consistently.
PowerShares FTSE RAFI US 1000 Portfolio (
PRF is based on RAFI index that aims to select stocks based on
four fundamental measures viz, book value, cash flow, sales and
dividends. The 1,000 equities with the highest fundamental
strength are weighted by their fundamental scores.
Exxon Mobil, Bank of America and GE are among the top holdings
but the asset base is pretty well spread out, with top 10
holdings accounting for just 18% of the total.
PRF has returned 143.4% in the last five years compared with
94.2% for the iShares Russell 1000 ETF (IWB) and 114.3% for SPDR
S&P 500 ETF (SPY).
The product charges an expense ratio of 39 basis points and has a
daily trading volume of about 115,000 shares.
S&P 500 Low Volatility ETF
Though the low-volatility concept is relatively new in the ETF
universe, it has become extremely popular of late. SPLV was the
first product in this space and is so far the most popular, with
more than $3.8 billion in assets. The product is based on the
research that low-volatility stocks have produced better
risk-adjusted returns in all markets over long-term.
SPLV tracks the performance of 100 stocks from the S&P 500
Index with the lowest realized volatility over the past 12
months. The ETF currently has an attractive 12-month yield of
2.8%, while it charges a low expense ratio of 0.25% per year.
In terms of sector allocation, Utilities (25.7%), Consumer
Staples (19.4%) and Financials (18.2%) take the top three spots.
The fund is pretty spread out in terms of individual holdings
with the top holding J&J accounting for just 1.3% of the
While the product underperforms the broader market in strong
bullish periods due to its focus on defensive stocks, it has
managed to beat the broader market since its inception, while
keeping the risk at a much lower level.
Looking at the longer term performance of the index, S&P Low
Volatility index had an annualized total return of 14.5% compared
with 13.9% for the S&P 500 Total Return index.
Guggenheim S&P 500 Equal Weight ETF
Equal weighted indexes are the simplest form of Smart Beta
indexes. This fund tracks the S&P Equal Weight Index,
putting roughly 0.2% in each stock. The success of the product is
mainly a result of its greater focus on mid-cap stocks compared
with the market-cap weighted index.
From a sectors perspective, the fund assigns almost equal weights
(16.3%) to Consumer Discretionary and Financials, while
Information Technology, industrials and healthcare also have
The ETF charges 40 basis points in fees per year from investors,
and has managed to attract $5.2 billion in total assets. With a
decent daily volume of 750,000 shares, the bid/ask spread are
RSP has returned 25.3% year-to-date basis, compared with 21.3%
for SPY. Looking at the longer-term, RSP has returned
147.4% compared with 114.3% for SPY in the trailing five-year
Not all "Smart Beta" funds have outperformed their market-cap
weighted cousins. Further they usually have slightly higher
expense ratios and also come with higher trading costs. But some
of them have been consistently delivering better results and are
worth a look.
To begin with, investors should use products based on simpler and
more transparent alternative methodologies that are easier to
Want the latest recommendations from Zacks Investment Research?
Today, you can download
7 Best Stocks for the Next 30 Days
Click to get this free report >>
PWRSH-FTSE RAFI (PRF): ETF Research Reports
GUGG-SP5 EQ ETF (RSP): ETF Research Reports
POWERSH-SP5 LVP (SPLV): ETF Research Reports
To read this article on Zacks.com click here.
Want the latest recommendations from Zacks
Investment Research? Today, you can download 7 Best Stocks for
the Next 30 Days. Click to get this free report