ETFs have become extremely popular in the investment industry. If you have some savings, you might already have some of them in your portfolio.
They have been the most disruptive product to enter the finance market in the last 50 years.
An ETF is a financial asset that replicates an index and can be bought and sold like a stock. It is defined as a passive investment.
Everyone knows that, most of the time, a mutual fund invested on American market rarely does better than its benchmark, the S&P 500 index.
This is the reason why the Vanguard S&P 500 ETF has a market cap of $500 bn. Active, managed funds that have been around for decades have been dumped in favour of passive investments, such as ETFs, because it is very hard to do better than them.
Hard, but not impossible. This is why, especially if you want to invest in a very particular sector, such as biotech or renewable energy, some mutual funds can still be a very good investment opportunity.
Selecting the good ones is not a trivial task, and understanding what they are doing and where they are investing is much harder than with ETFs. This is why the majority of retail investors wisely go for passive investment.
Since passive investment is quite saturated as a market, in order to innovate, ETF producers had a good idea. They invented Smart Beta ETFs, which are something in between an active and passive investment.
To invest on a stock index, you can passively invest in a portfolio of stocks that replicates it, or you can choose a different basket in order to achieve better returns or lower risk. It is a binary choice. You cannot be passive and active at the same time.
Most of ETFs on the S&P 500 have a beta close to 1. This means that they are expected to move up and down as much as the index they are replicating.
By using the word “smart” in the name, it implies that there is a way to achieve the same return while running less risk.
If someone tries to Google information about it, he will end up with a lot of conflicting information. Smart betas are often seen as a holy grail, sometimes in an attempt to revitalize a matured market.
In financial newspapers, many journalist have said that, finally, thanks to smart betas, it was possible to do something less boring than just buying or selling an index; for example, when using normal ETFs, but without paying the expensive commission that mutual funds have.
On the contrary, many people have said that smart betas are more expensive and the simple ones aren’t worth it, that they are just an attempt made by the producer to revitalize a saturated market.
Mutual funds do not give better returns than passive investments because of their huge commission and transaction costs, but some asset managers are talented enough to offer better risk-adjusted returns than the benchmark index. In other words, they could generate alpha if they had smaller costs.
Smart beta ETFs should have been called alpha-seeking ETFs, because their goal is to beat their benchmark index by selecting a subset of it.
The simple ETF, however, is just a replica of the index.
The difference between a mutual fund and a smart beta is still large. The first one has a manager that can, at any time make new investment decisions.
A smart beta has a fixed criterium to select the component in which it will invest. But there is no human intervention, so it is a purely systematic strategy.
The most popular systematic strategies used to construct smart betas, and that have shown better performance, are those that are similar to well-known, common-sense stock-picking criteria. For example, buying the less volatile S&P 500 components or companies that have a record of increasing dividends over time.
Some of these stocks’ selection models have, historically been done very well and have generated a good alpha.
In terms of costs, they are more expensive than their older brother, the vanilla ETF, but still much cheaper than their grandfather, mutual funds.
I personally use them in the long-term part of my portfolio.
If someone is curious to see where he could find more information and data, I suggest using a free tool such as etf.com or justetf.com.
The following is a brief description of some of the most popular ones:
-Vanguard value: it uses rules to determine which company is under-valuated, such a price-to-earning or price-to-sales ratio.
-Xtrackers S&P 50Xtrackers S&P 500 ESG 0 ESG: it excludes from the index companies dealing with weapons, tobacco, or those with a low score in the United Nations global compact.
-iShares Edge MSCI USA Momentum FCTR ETF: invests in large stocks that have shown strong price momentum based on the stock’s short-term performance.
SPDR S&P Dividend ETF: invests in the “aristocrats,” which are the stocks that have increased their dividend pay outs for 25 consecutive years.
-Invesco S&P 500 Low Volatility: it invests in the 100 least volatile companies.
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