Smart-Beta ETFs: Alternative Portfolio Allocation Beyond Market Cap

What is a smart-beta ETF? Explore what qualifies as a smart-beta fund and what systems define this type of ETF.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Light bulb math: smart beta ETFs
5 min read
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Key Takeaways

  • A smart-beta ETF offers an alternative to traditional funds that typically allocate by market capitalization

  • Smart-beta funds can help an investor tailor investments to personal objectives 

  • Not all smart-beta funds offer the same risks and growth potential, and these funds often come with higher fees compared to an index fund

Most investors have heard the mantra: “Diversify, diversify, diversify.” When you invest in a variety of assets, you can potentially reduce risk in a portfolio by not putting all of your money into one area.

Investors can try to achieve diversification in several ways. They may simply purchase stocks from different sectors or stocks of different companies within a particular industry. Or they may buy shares of mutual funds, which are investments in a collection of assets overseen by a professional portfolio manager.

One increasingly popular way investors try to get exposure to a broader variety of securities is through shares of an exchange-traded fund, or ETF.

In recent years, so-called “smart-beta” ETFs have started to attract attention for their alternative selection and prioritization criteria for stocks or other securities the fund holds. Traditional ETFs typically weight holdings by company size or market capitalization (“market cap”), whereas smart-beta ETFs may focus on other metrics to determine allocations. So smart-beta ETFs can provide another strategy for investors who want to take advantage of the potential benefits of ETF investing.

How Do Exchange-Traded Funds Work?

Investors can use ETFs in a variety of ways depending on their investment goals. Some may want to invest in dividend-paying ETFs that can target income during retirement years. Others may wish to invest in a particular sector without investing in a specific company.

No matter how you go about investing in ETFs, there are several things to consider as you choose an ETF that matches your goals.

ETFs can help investors diversify a portfolio much like buying a variety of stocks or shares of a mutual fund, but ETFs might be easier to trade. Just as the name implies, exchange-traded fund shares are bought and sold on an exchange, so investors buy into these funds just as they buy stock in individual companies. ETF shares can be bought and sold anytime during the trading day through a brokerage account.

Unlike mutual funds, ETFs are typically not actively managed but follow a particular group of assets. Some ETFs, however, are actively managed. For example, an ETF may follow the broader S&P 500 Index (SPX) or the NASDAQ Composite Index (COMP), or it might follow particular sectors such as only bank stocks or only technology stocks.

What Is a Smart-Beta ETF?

Smart-beta funds track an index much like traditional ETFs, but use different metrics. The basket of stocks for a traditional ETF is weighted according to market cap, so larger companies will comprise a larger share of the fund than smaller ones. For investors who are looking to prioritize other metrics in determining portfolio allocation, traditional ETFs may not be ideal.

ETF issuers have continued to offer new combinations of alternative weightings and other selection criteria through smart-beta ETFs.

Smart-beta ETFs rely upon certain factors—aside from just market cap—to determine their index weightings. Such factors include:

  • Volatility. Lower volatility can mean lower risk-adjusted returns. There are smart-beta ETFs that can allow investors to target volatility trends. For example, some smart-beta ETFs now include holdings that have lower volatility relative to the broader market for a more defensive strategy.
  • Momentum. Sometimes, outsize returns run in trends. Momentum funds seek to capitalize on possible short- and longer-term trends.
  • Value. Some funds rank according to stock price relative to the company's intrinsic value. Learn more about value investing.  

What Are Some Recent Trends in Smart-Beta Funds?

Smart-beta ETFs can use a number of different strategies for weighting companies. Lately, some value-based smart-beta ETFs have begun focusing on financial metrics such as earnings, sales, or cash flow to construct the fund’s portfolio. Just as there are many ways to determine what constitutes a “value stock,” there are many ways to rank such stocks when determining the weighting of a smart-beta fund.

Some smart-beta ETFs rank holdings by dividends or focus on international diversification by ensuring that a portfolio has particular exposure to different global markets. There are even smart-beta funds that provide equal weight to all the stocks in the fund.

These are just a few examples of recent trends in smart-beta funds, but ETF issuers continue to find new alternatives.

How Do You Invest in a Smart-Beta ETF?

Not all smart-beta ETFs offer the same risks and growth potential, so be sure to research any ETF you want to buy. Also, be aware of any fees associated with a smart-beta ETF, as they can sometimes be higher than fees for a traditional ETF. For TD Ameritrade clients, the list of 550+ commission-free ETFs includes a number of smart-beta alternatives. 

If you’re interested in looking outside the world of market-cap-based allocation, smart-beta ETFs might be worth considering. 

Before investing in any ETF or Mutual Fund, carefully consider the investment objectives, risks, charges and expenses. A prospectus, should be obtained as it contains this and other important information about an investment company. Read carefully before investing.

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Key Takeaways

  • A smart-beta ETF offers an alternative to traditional funds that typically allocate by market capitalization

  • Smart-beta funds can help an investor tailor investments to personal objectives 

  • Not all smart-beta funds offer the same risks and growth potential, and these funds often come with higher fees compared to an index fund
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*ETFs are subject to risk similar to those of their underlying securities, including, but not limited to, market, investment, sector, or industry risks, and those regarding short-selling and margin account maintenance. Some ETFs may involve international risk, currency risk, commodity risk, leverage risk, credit risk, and interest rate risk. Performance may be affected by risks associated with nondiversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities (especially emerging markets), real estate investment trusts (REITs), fixed income, small-capitalization securities, and commodities. Each individual investor should consider these risks carefully before investing in a particular security or strategy. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Information provided by TD Ameritrade, including without limitation related to the ETF Market Center and commission-free ETFs, is for general educational and informational purposes only and should not be considered a recommendation or investment advice.

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Particular commission-free ETFs may not be appropriate investments for all investors, and there may be other ETFs or investment options available at TD Ameritrade that are more suitable.

Short-Term Trading Fee (Holding Period for 30 Days). ETFs available commission-free that participate in the ETF Market Center may be subject to a holding period that commences with any purchase and extends through the following THIRTY (30) calendar days. An account owner must hold all shares of an ETF position purchased for a minimum of THIRTY (30) calendar days without selling to avoid a short-term trading fee where applicable. There is no limit to the number of purchases that can be affected in the holding period. Any order to sell within THIRTY (30) calendar days of last purchase (LIFO—Last In, First Out) will cause an account owner’s account to be assessed a short-term trading fee of $13.90 where applicable. For the purposes of calculation the day of purchase is considered Day 0. Day 1 begins the day after the date of purchase. The short-term trading fee may be applicable to each purchase of each ETF where such ETF is sold during the holding period. The short-term trading fee may be more than the applicable standard commissions on purchases and sells of ETFs that are not commission-free.

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