Are Smart Beta ETFs Active or Passive?

Smart Beta ETFs have surged in popularity in the past few years. Also called factor investing or strategic investing (Morningstar Inc.’s name for it), smart beta strategies seem to fall somewhere in between passive indexing and active management.

Factor investing uses a set of easily definable characteristics to produce a universe of stocks that meet certain criteria. For instance, the value factor looks at metrics like P/E ratio to find stocks that are priced below that of their peers. This makes factor investing more specific than asset class investing, where all stocks get lumped into a few pre-defined buckets, but still much less specific than what is usually considered an active strategy of stock picking. Here are some examples of funds or indexes tracking the 5 most common factors.

Value – The MSCI USA Enhanced Value Index looks at 3 variables in the large and mid-cap US stock world. Stocks that meet criteria using price-to-book value, price-to-forward earnings and enterprise value-to-cash flow from operations are included in the index, and while it isn’t possible to invest directly in the index, there are ETFs such as the iShares Edge MSCI US Value Factor EFT (VLUE) that attempt to track it.

Size – Invesco’s S&P Small Cap 600 Equal Weight ETF tracks the S&P Small-Cap 600 Equal Weight Index. This index is comprised of US stocks with a capitalization range of $400 million to $1.8 billion. The size factor comes from research showing that historically, smaller companies out-perform larger ones over the long term.

Momentum – The Vanguard U.S. Momentum Factor ETF (VFMO) selects US stocks with the potential to generate higher returns relative to the broad U.S. equity market by investing in stocks with strong recent performance as determined by the advisor. While this is relatively vague, momentum is often defined by medium term (3-12 months) performance, the theory being that stocks which have been performing well will continue to do so.

Low Volatility – The Fidelity Low Volatility Factor ETF (FDLO) tracks the Fidelity Low Volatility Factor Index, which is designed to reflect the performance of stocks of large and mid-capitalization U.S. companies with lower volatility than the broader market. This ETF outperformed the S&P 500 in 2018 with less volatility.

Quality – This factor can be a little harder to define than the others and there is more variance in what is used to determine quality. The Invesco S&P International Developed Quality ETF tracks the performance of stocks in the S&P Developed ex-U.S. Large Mid-Cap Index that have the highest quality score. The score is calculated from return on equity, the accruals ratio and the financial leverage ratio.

Most of these smart-beta funds and their indexes are more than just traditional market-cap weighted ETFs. Stocks must be constantly re-evaluated for inclusion and there are often several criteria that need to be met to be considered. Still, factor investing is not as involved as traditional active management even though its goal is to generate above market returns.

While most smart beta ETFs are more expensive than traditional index funds, they are often far cheaper than traditional actively managed funds. Invesco’s Quality fund, for instance, has a total expense ratio of .29%. Though they are relatively inexpensive to own, outperformance is not a given. Some factors perform better than others in any given market situation, and as a result many factor investment strategies use multiple factors in a portfolio and will change the weights of those factors in response to market conditions.

Smart beta can probably be considered a hybrid of passive and active management. Regardless of where opinions fall, though, it is an intriguing deviation from traditional asset class investing that is worth exploring for any diversified portfolio.