What Are Smart Beta Funds?

Index funds are generally comprised of public companies grouped by market capitalization. For example, you may have a large cap index fund linked to the S&P 500 Index, or a small cap index fund linked to the Russell 2000.

Smart beta funds are similar, but instead of market capitalization, the index holdings are grouped by other factors such as value, momentum, lower volatility or quality.3 They’re also sometimes referred to as strategic beta, alternative beta or advanced beta.4 They were created as a means of improving on index investing by establishing a different set of rules to select, weight and rebalance an index.

A smart beta fund is therefore designed to track this version of an index that is comprised of individual investments that meet the “smart beta” criteria. Management fees tend to be competitive with those for passive index-based exchange traded funds and significantly lower than actively managed funds.

Smart beta funds may offer many of the same benefits of index funds, including broad market exposure, diversification, liquidity, transparency and low cost access to markets.5 However, they also provide a way to take advantage of a particular market factor that may offer the opportunity for higher returns within the context of a well-constructed portfolio. For example, a smart beta index may be based on:

• Company earnings
• Dividends
• Cash flow
• Credit ratings
• Reducing volatility
• Capturing price momentum6

Some smart beta funds combine a variety of factors (“multifactor smart beta funds”), in an attempt to generate higher returns than exposure to a single factor fund, which may suffer from a lack of diversification apart from that factor.

Keep in mind that smart beta funds should be evaluated based on an investor’s specific financial needs, personal objectives, investing time horizon and risk tolerance. Be aware that smart beta funds may underperform cap-weighted benchmarks and increase portfolio risk. Before investing, you should consult a qualified financial professional.

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