Institutional investors have used alternative weighting and factor-driven strategies since the 1970s, though no one called them “smart beta” back then. Now that the term has become mainstream, nonmarket-cap-weighted ETFs have gained steam.
“Smart beta” approaches are currently the fastest-growing segment of the ETF marketplace, pulling in assets at twice the rate of the entire ETF market.
“The default setting for an ETF, a non-strategic beta ETF, is to be tied to an index whose components are weighted by market capitalization … A strategic (or “smart”) beta ETF, on the other hand, has its components weighted by some other criteria.”
Advantages & Disadvantages Of Smart Beta
To use smart beta effectively, you need to:
- Be able to identify which factor(s) can produce alpha
- Be able to identify when that factor will come in and/or out of favour via a market environment change
You may also need to overcome some disadvantages of smart beta; namely, the following:
- Ask yourself, does the expected alpha overcome higher expense ratios?
- More concentrated portfolios can increase return but they can also increase stock-specific risk.
- Wider spreads on trading these less liquid products require one to ask whether the expected alpha outweighs the risks.
Managing risk to the upside and downside via low-volatility and higher-volatility ETFs seems to be the most valid use of smart beta