The Pros And Cons of Smart Beta ETFs

Many investors have traded in their passive indexes for smart beta ETFs over the last five years as these innovative strategies have shown promising results. The allure of creating a “better investment strategy” is an admirable objective for these semi-active funds. However, investors need to fully understand how the index is constructed and how much more they will pay in fees before deciding to invest in this arena.

Charles Rotblut, Vice President of the American Association of Individual Investors, recently wrote an excellent article about how to define and categorize smart beta ETFs. His analysis centered on the fact that there is no central repository or classification system for these funds. Rather, each investor has to decide for themselves whether an index is truly making substantive changes to its holdings in response to shifting conditions or just an innovative strategy.

His analysis culled 59 ETFs from the universe of over 1,600 funds that were considered in his eyes to be smart beta. Although, I would argue that equal weight ETFs should probably not fall into this category because the only thing innovative about them is their allocation sizes. In addition, I found that he may have unintentionally missed some key smart beta sector funds from First Trust that could have rounded out this guide.

Ultimately we both agree that smart beta investing is a perceptive exercise that may take different forms and meanings to each individual. The most obvious examples generally include fundamental or performance-based characteristics that are evaluated on a regular basis to identify the top rated stocks in each category. These can include factors such as price momentum, balance sheet characteristics, dividend yield, or a combination of several traits.

For example, the First Trust Consumer Staples AlphaDEX Fund (FXG) is constructed of approximately 40 stocks in the consumer staples space that are chosen according to a variety of value and growth metrics. This includes price appreciation, book value, sales growth, cash flow, and return on assets. The end result is a unique portfolio of companies that varies significantly from the sector benchmark Consumer Staples Select Sector SPDR (XLP).

The combination of these factors has led to FXG outperforming XLP by a fair margin on 1, 3, and 5-year time frames as of the last fiscal quarter. Much of that alpha has been driven by exposure to small and mid-cap companies that have outperformed their large-cap peers during this most recent bull market. It’s conceivable that during a protracted downtrend, these smaller companies may lead on the downside and cause a wave of underperformance in similar smart beta funds.

In addition, it’s worth noting that many smart beta funds have significantly higher expense ratios than their passive counterparts. In the aforementioned example, FXG charges expenses of 0.70% compared to 0.16% for XLP. Over the last several years, that premium cost has been worth paying to achieve a markedly stronger performance gain. However, it may lead to additional angst during the next slow growth cycle.

The suite of iShares factor ETFs that focus on momentum, volatility, value, and quality are probably the lowest cost smart beta funds with expenses of just 0.15% annually. As an example, the iShares MSCI USA Quality Factor ETF (QUAL) selects 125 stocks with that are exhibiting positive balance sheet fundamentals. Holdings in the index are then reevaluated and rebalanced quarterly.

WisdomTree has been a smart beta pioneer for many years now and has popularized fundamental security selection based on high dividend paying stocks. The WisdomTree Small Cap Dividend Fund (DES) has now been in existence for more than five years and shown to be a worthy competitor to a passive index such as the iShares Russell 2000 ETF (IWM). The focus on selecting holdings and weighting them according to dividend payouts is a concept that has been embraced by yield-hungry investors.

There is no doubt that smart beta strategies are here to stay and additional concepts will be introduced that continue to push the envelope for alpha-seeking investors. One key to successfully integrating these ETFs in your portfolio is to regularly monitor updates to their holdings to ensure they stay in line with your risk tolerance and investment objectives. In doing so, you will have a better understanding of how the funds adapt to various circumstances and how they perform versus passive benchmarks.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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