Although plain-vanilla index funds still dominate the exchange-traded fund landscape, alternative-weighted funds known as “smart beta” are maturing. After more than a decade of real-world performance, both investors and financial advisors have grown more familiar with how they operate and some use them as portfolio building blocks.
In a just-released ETF study by Charles Schwab, the results found that 41 percent of ETF investors currently use smart beta strategies. Moreover, during volatile markets, such as what we’ve experienced in October, more than 70 percent of investors are interested in smart beta to manage the rough waters.
According to Morningstar, 302 smart beta ETFs were launched last year, and through mid-2018 there was almost $900 billion invested in these types of funds.
The term smart beta was first introduced in the 1970s by consulting firm Towers Watson. Today, smart beta refers to the use of alternative weighting and security selection methods that run counter to traditional market cap-weighted indexes.
While institutional investors have used smart beta strategies for decades, it wasn’t until the early 2000s when the technique started being packaged inside an ETF wrapper.
The Invesco S&P 500 Equal Weight ETF (RSP), launched in 2003, is generally considered the first U.S.-listed smart beta ETF. While RSP holds the same 500 stocks contained within the S&P 500, each stock is assigned an even-weighted percentage of 0.20. Instead of having an index dominated by companies with the largest market size as the traditional market cap-weighted S&P 500 does, the equal-weight version gives all 500 stocks the same voice or weighting.
Smart beta ETFs come in a variety of flavors. Some focus on single factors such as dividends, revenue, momentum, and value or growth attributes, among others. And some funds, like the Oppenheimer Russell 1000 Dynamic Multifactor ETF (OMFL), package a variety of factors simultaneously. For example, OMFL provides exposure to specific factors including momentum, value, quality, size and low volatility.
Why would an advisor use smart beta ETFs? According to BlackRock, the reasons can include customizing portfolios to a range of risk tolerances, replacing underperforming style box managers or seeking lower-cost sources of excess returns.
ETFs that minimize volatility may become especially appealing in turbulent markets. For example, while the S&P 500 Volatility Index (VIX) has surged over 70 percent since the start of October, the iShares Edge MSCI Minimum Volatility USA ETF (USMV) has slid just 5 percent this month. That’s better than broad market U.S. funds like the Schwab U.S. Stock Market ETF (SCHB), which has declined 9.4 percent over the same period.