What is a smart beta ETF?
Although not all ETFs track an index, ETFs are primarily associated with the concept of index investing.
The original idea behind index investing was that since it is very difficult to "beat the market", an investor should just "own the market". So the original ETFs that were launched during the late 1990s and early 2000s were based on well known broad market indexes like the S&P 500 Index (large cap stocks) or the Russell 2000 Index (small cap stocks). These indexes were market capitalization weighted indexes, which made sense if you wanted an index to track the market. You can read more about indexes in our introductory educational article called what is an index?.
In the year 2000, iShares launched the first ETFs that tracked indexes that were designed to outperform the market, rather than just mirror the market. At that time, the primary way that investors thought they could outperform the market was to own either "value" stocks or "growth" stocks. So iShares launched a series of ETFs that were either value ETFs or growth ETFs.
The value ETFs that were launched were fairly straight-forward, as they selected stocks that were "inexpensive" using measures like market value compared to book value. The growth ETFs were a little more complicated to understand, because they were using a variety of methods to select "growth stocks", including fundamental factors about a company such as sales growth, but also technical factors about the stock like price momentum.
Each of the major index providers (MSCI, S&P, Morningstar, Russell, etc...) had their own method of creating a "growth index", as we will discuss below. But they all generally followed a similar framework. The idea was to classify all stocks into one of three buckets: growth stocks, value stocks, and stocks that were "neither". The "neither" group of stocks was alternately referred to as "core" stocks, or "blend" stocks.
The growth indexes were the most complicated to understand. Lets look at a few examples. IVW, the iShares S&P 500 Growth ETF,which was launched in 2000, tracks the S&P 500 Growth Index, which measures growth using three factors: sales growth, the ratio of earnings change to price, and momentum. As another example, VUG, the Vanguard Growth ETF, which was launched in 2004, tracks the performance of the CRSP U.S. Large Cap Growth Index. CRSP classifies growth securities using the following factors: future long-term growth in earnings per share (EPS), future short-term growth in EPS, 3-year historical growth in EPS, 3-year historical growth in sales per share, current investment-to-assets ratio, and return on assets.
So these older style "growth" indexes were actually selecting stocks using several "investment factors". An investment factor is any fact or statistic about a company that might explain why the company's stock performs either well or poorly.
For about ten years, this notion of everything being a growth stock or a value stock prevailed. As time went by, and more and more research was done into investment factors, the investment community began to think more and more in terms of "investment factors" rather than just value stocks versus growth stocks. Index providers began to develop indexes that were selecting stocks using a variety of investment factors, besides just value versus growth.
At some point, ETF providers coined the term "smart beta ETFs" to refer to ETFs that are tracking an index designed to outperform the market. Morningstar uses the term "strategic beta" ETFs. Some ETF providers also use the term "factor ETFs" when talking about smart beta ETFs.
With today's terminology, the older "growth ETFs" would be labeled as "multi-factor ETFs", since most growth indexes are selecting stocks using multiple factors like quality and momentum. Regardless of the terminology, the goal is the same: can you build an index that outperforms the market? Throughout stoxray.com, we use the term "smart beta ETF" to reference any ETF that is based on an index that is not simply passively tracking a well known index like the S&P 500 or the Russell 2000.
We should note that not all smart beta ETFs are designed to outperform the market. Some smart beta ETFs, such as those that are dividend focused, are merely trying to achieve a higher dividend yield with less volatility, even if that means a slight under-performance compared to the market.
We should note too that the framework from the 1990s that all stocks should be classified between growth, value and blend continues to exist, and you will still see references to it all the time. Throughout our website, we use the newer terminology of talking about stocks using factors. For example, the older ETFs that track old style "growth" indexes are referred to as "multi-factor" smart beta ETFs.
Smart beta approaches today
There are currently three different approaches to creating a smart beta index that will (hopefully) outperform the market:
- Build an index that weights its holdings using some other method besides market capitalization
- Build an index that selects the stocks to be included in the index using one or more investment factors
- Build an index that combines both of the above methods
There are quite a few smart beta ETFs that do nothing more than change the weighting method of the index to something other than market capitalization. RSP, the Guggenheim S&P 500 Equal Weight ETF, tracks the S&P 500 Equal Weight Index, which is an index of every stock in the S&P 500 Index, but weighted equally rather than by market capitalization.
Investment factor definitions
What investment factors cause one stock to outperform another stock over long periods of time? There isn't necessarily a standard set of definitions. On our website, we have classified every smart beta ETF by the types of factors the index is using to select stocks. Here are the factor definitions that we are using:
- Quality - is a company profitable?
- Growth - is a company growing?
- Value - is a company's stock reasonably priced?
- Volatility - is a company's stock less volatile than average?
- Momentum - is a company's stock in an upward trend?
- Dividends - does a company pay stockholder dividends?
- Investments - does a company make wise investments?
- Fundamental factors - is the company a "solid" company if you look at its financial statements?
- Other
Note that these factors are sometimes referred to as sources of "Alpha". When analyzing the performance of a portfolio, someone came up with the formula that the return of a portfolio is attributable to two factors: 1) "Alpha" - what the portfolio manager did to outperform the market; and 2) "Beta" - the return of the market itself. So some people refer to investment factors as sources of "Alpha".
Academic factor research
Over the past 30 years, academic researchers have attempted to develop scientific models to explain the performance of the stock market over long periods of time. What factors cause one particular stock to do well compared to another? With 100 years of stock market history, researchers can run complex regression and statistical models to determine which measurable factors allow one stock to outperform another.
This research is generally performed by constructing sample portfolios. Using data on 3,000+ stocks, mostly from the last 30 years or so, researchers generally construct sample portfolios by sorting the data on the 3,000+ stocks using different criteria, or factors, like the size of the company, the profitability of the company, the price of the company's stock relative to earnings, etc... They then measure which of these sample portfolios perform better than the market as a whole.
For example, what happens if you construct a portfolio of the 100 stocks with the highest dividend yield? Does it perform better or worse than the market? If it performs better than the market, the researcher then applies advanced statistics to determine if the excess performance was statistically significant, or meaningful. Perhaps the excess performance was random luck.
The analysis gets more complicated because researchers have to form portfolios using multiple factors. What happens if you construct a portfolio of 100 stocks with the highest dividend yield and the lowest price to earnings ratio? What happens if you construct a portfolio of 100 stocks with the highest dividend yield, the lowest price to earnings ratio, and the lowest volatility? The statistics quickly get very complex.
Read our article on academic factor models for more information on this research.
Is this a good idea?
The number and complexity of smart beta ETFs is starting to be overwhelming. They are using a wide variety of approaches, and you have to carefully study the fine print. Most are using indexes that were just recently invented, and many do not have theoretical backtest data showing how the index would have performed in the past. As a result, there are some newly launched smart beta ETFs where it is impossible to know whether they will be a good ETF or not.
One simple reason the ETF industry has grown is because there are too many actively managed mutual funds (8,000+), and it is difficult to filter through them to figure out what to buy. Smart beta ETFs are starting to become the same way. It takes so much research to figure out what they are doing that there are definitely times when it does not seem worth the effort.
Investors have to decide if smart beta ETFs are worth it. There are still many true believers in passive index investing. It is hard to argue too much with an investor who constructs a simple portfolio of three or four low cost ETFs. You can easily and cheaply own the world's stock market by buying three ETFs:
- VTI, the Vanguard Total Stock Market ETF
- EFA, the iShares MSCI EAFE ETF, which tracks developed markets except the U.S. and Canada
- VWO, the Vanguard FTSE Emerging Markets ETF
So not everyone would agree that you have to buy into the smart beta ETF mania. Nevertheless, there are some smart beta ETFs that seem compelling. We have tried to analyze each smart beta approach in a series of articles describing and analyzing each approach. Please read them.
Do smart beta ETFs have higher fees?
The ETF industry has gotten very competitive, pushing fees lower and lower. ETFs based on broad market indexes like the S&P 500 and the S&P Small Cap 600 Index have gotten very cheap. So smart beta ETF fees are definitely higher than the fees associated with these well-known market indexes.