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What to Look for in ‘Smart-Beta’ ETFs


With fund sponsors coming up with new ways to invest in the market, exchange traded fund investors can now passively track so-called smart-beta, factor-based, strategy indices that provide active styles.

Traditional beta-index ETFs passively reflect major capitalization weighted market indices and segments. On the other hand, strategy ETFs provides alternative exposure that tries to beat the market or track a type of enhanced exposure, according to Samuel Lee, a strategist for Morningstar.

“These ETFs are what you could call quasi-actively managed because they do represent active tilts against the market,” Lee said.

For instance, the strategy ETFs select component stocks based on cash flow, book value, sales, dividends, volatility and momentum, among others.

Lee highlights the iShares suite of Factor ETFs, specifically the quality and momentum offerings, due to their cheap expense ratios, with most of them coming in at 0.15%, and component inclusions based on sound academic research.

The Factor ETFs include the iShares MSCI USA Quality Factor ETF (QUAL) , iShares MSCI USA Size Factor ETF (SIZE) , iShares MSCI USA Value Factor ETF (VLUE) and iShares MSCI USA Momentum Factor ETF (MTUM) .

The iShares MSCI USA Quality Factor ETF provides a type of Warren Buffett portfolio of companies with high profit margins, low earning variability and low debt.

“They basically look for companies that Buffett would consider a high-quality,” Lee said.

Lee’s other pick, the iShares MSCI USA Momentum Factor ETF, follows a disciplined approach to exploit momentum. However, MTUM is more expensive than the others because of its turn over rate.

“It seems like a dumb strategy; that is you’re chasing returns up and you’re kicking out losers, things that have gotten much cheaper,” Lee added. “But historically this has been a very powerful strategy that has worked in virtually every market that’s been examined.”

Depending on an investor’s comfort level, strategy ETFs can be used as alternatives for core holdings. Lee likens switching out core holdings for strategy ETFs as something similar to using actively managed funds as a core holding. However, for those less comfortable with strategy ETFs, these offerings may also be used in a smaller tactical tilt.

“If you are comfortable owning actively managed mutual funds in your portfolio as your core holdings, as many investors do, then there’s nothing that would prevent you from owning these factor or strategy ETFs as your core holdings,” Lee said.

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.