Are Smart Beta ETFs better investment?

With the precipitous flow of investments into passive index funds and exchange traded funds (ETFs), the vast majority of cash in the market is tied to the performance of broad-based market indexes like the S&P 500, the Nasdaq Composite or the Russell 2000.

While most financial advisors are the ones steering investments into these funds, many investors don’t know that there are other vehicles in the passive investment space.

Smart Beta, Smart Returns

Enter smart beta—an alternative to traditional fund composition that analyzes other market-based metrics to define an investment strategy. Because these strategies can vary wildly, smart beta is defined less by what it is than what it is not.

Essentially, the smart beta label applies to any “rules-based” investment strategy—meaning the strategy is defined by clear rules rather than the whims of a fund manager—that aims at delivering superior and “disruptive” returns compared to a traditional market-cap weighting, which is typical among the vast majority of index funds.

A new world of investing ideas

For example, the SPDR S&P 500 ETF (SPY) is a typical passive ETF whose components are selected and weighted according to the market cap of companies within the S&P 500 index. SPY’s goal is to match the performance of the index to scale.

The SPDR S&P 500 Buyback ETF, on the other hand, is a smart beta ETF whose components, while still drawn from companies within the S&P 500, is weighted according to an index that gives greater importance to S&P 500 stocks that have had buyback programs in the preceding 12 months. The assumption is that stock buybacks are proof that a company is confident enough in its financial future to buy back its own shares on the market, consequently increasing the value of the remaining shares. Investors in this ETF are likely in it to outperform the vanilla S&P 500 index.

That’s only one example. There are smart beta strategies that are guided according to a company’s cash flow, annual revenues, ROE (return on equity), or whether they have a dividend program. Some smart beta strategies even incorporate several rules into their structure.

Are they for everyone?

While smart beta’s unique approaches to passive investing might seem like a great way to beat the market, smart beta funds are generally more expensive than their less exotic counterparts, and each strategy poses specific risk factors.

What’s more, although they aren’t at the whims of an active fund manager, smart beta funds have a spotty performance history compared to typical index fund and require some careful research on the part of investors if they want to have a chance to outperform the broader market. Like a stock picker, picking the right smart beta fund can be quite a challenge for investors.

Regardless, investors curious about the specific rules governing a particular smart beta (or any passive) index fund should always remember to read the fund’s prospectus and find out about funds’ stated objectives, portfolio composition and expected benchmarks.

Smart beta isn’t the magic middle ground between active and passive investing. Each approach to smart beta, like all approaches to the stock market, has its risks and rewards, but no guarantees. If some of these ideas to investing sound appealing, investors should research exactly what each strategy can be expected to deliver in terms of returns and find the strategies that best match their risk tolerance.