What to know before investing in smart beta ETFs

What is strategic/smart beta? We’d define it as an investment strategy that employs a rules-based approach designed to screen an investment universe for securities with certain factors that are believed to offer the opportunity for better returns, less (or sometimes more) risk, or a specific outcome.

And what is a factor? A factor is an investment characteristic that research has shown to drive performance over time. Common factors include value, profitability, size, momentum, and volatility.

Furthermore, strategic beta strategies that employ factors typically fall into two main groups: single factor and multifactor. We believe multifactor strategies are attractive long-term, core portfolio holdings because it proves difficult to predict which individual factors will outperform in advance. Therefore, we think it makes sense to diversify factor exposure with multifactor strategies.

Single-factor strategies are a bet on an individual factor, much like the way investing in a technology fund is a bet on a single sector. Different factors, like different sectors, tend to perform better or worse in certain economic environments, and seeking to exploit a single factor for greater returns also can expose an investor to greater volatility. Using multifactor strategies as a core holding, while using single-factor strategies as satellites to tilt your portfolio to a particular factor you want to temporarily overweight, may be another way to think about how to use the different types of factor-based strategies.

Properly defining strategic beta is key because the term is admittedly a somewhat vague catchall.

The wide variety and number of strategic ETFs only add to the challenge. For example, there are nearly 1,000 strategic beta ETFs with over $1 trillion of total assets.¹ Most of the largest strategic beta ETFs are single-factor ETFs for growth, value, dividends, and low volatility.

However, we believe there is room for growth for multifactor ETFs as long-term holdings because they may help investors stay on track when individual factors are underperforming.

Indeed, part of what’s fueling the rise of strategic beta ETFs is the increasing adoption of the strategies by investment professionals in client portfolios.

To recap, we view strategic/smart beta ETFs—and particularly multifactor ETFs—as an attractive third way to invest that lands between active and passive. Some individuals and investment professionals may like the transparency and rules-based approach of multifactor investing combined with the tax efficiency of the ETF structure. Also, multifactor ETFs have at least the potential to outperform market-capitalization-weighted indexes, although nothing is guaranteed.

When evaluating the investment approach of smart beta ETFs, we think it makes sense to start with two questions:

• What specific factors do I want to invest in?
• What are the rules behind the strategy?

The first question is a bit of a philosophical one, and the answer is determined by what the investor is trying to achieve, whether it’s lowering volatility or boosting performance, for example. It’s also important to remember that factor premiums (outperformance) may be driven by being rewarded for taking on more risk, or by exploiting a market inefficiency.

The second question involves understanding how the factor is defined and how the ETF’s tracking index is constructed. For example, is value determined by low price-to-earnings (P/E) ratios or some other metric? How often does the index rebalance? These are the questions that need to be answered, and the process is so important that we’ve even written about how investors can get started in multifactor ETF due diligence.

The good news is that we believe ongoing due diligence with rules-based smart beta ETFs is easier and simpler than purely active strategies. As with any investment, it’s crucial to fully understand how a smart beta ETF works before even considering purchasing it.

1 ETF.com, as of 10/21/20.

Price-to-earnings ratio: Price to earnings (P/E) is a valuation measure comparing the ratio of a stock’s price with its earnings per share.