Content provided by Joe Smith, CFA – CLS Senior Market Strategist

Smart beta ETFs continue to be a popular topic in the investment industry. They’ve created excitement because they follow indexes that intentionally deviate from a market-cap-weighted index and have deep roots in academic and institutional investment circles. This provides opportunities for additional risk management and return enhancement without having to significantly deviate from strategic long-term allocation policies with tactical investing.

So, how do you know if you are really getting what you pay for? At CLS, we take a very methodical approach to evaluating smart beta ETFs. This process looks similar to what an institutional investor would expect from an investment consultant when performing due diligence on an active manager.

1. Smart Index Selection Criteria

A rules-based index methodology is at the heart of every smart beta ETF. The methodology takes a well-known actively managed investment process and streamlines it into a set of decision criteria that can capture the majority of that investment process without divulging into nuanced security selection. Efficient smart beta ETFs have index methodologies whose rules are clear cut and repeatable over time without the need for human judgement.

2. Intelligent Combination of Factor Exposures

All smart beta ETFs result in an investment strategy that captures exposure to one or more factors common in investing, such as value, size, momentum, minimum volatility, quality, and/or dividend yield. An important consideration is how effective the smart beta ETF is in combining these factors to pare out unwanted risk and target the desired investment characteristics associated with the original strategy.

3. Balanced Weighting and Rebalancing Process

The final step in bringing any smart beta ETF to life is determining the portfolio weight of the underlying securities that made it through the rigorous selection process and how frequently the weightings should be refreshed. Both steps are critical to the stability and performance of any smart beta ETF. In any case, a good smart beta ETF should be designed to intelligently trade off the weighting approach and rebalancing cycle to ensure that risk, return, and trading costs remain balanced through time.

As more smart beta ETFs come online it will be critical for investors to have a consistent way to evaluate and identify the differences between each product. Not all smart beta ETFs are created equal, and being able to identify which ones are appropriate for portfolio selection can add value for investors over the long term. At CLS, we continue to focus on dissecting and understanding the smart beta ETF landscape in order to do just that.

Investing involves risk. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. This information is prepared for general information only.  It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report.  An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket.  ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in.

1595-CLS-5/3/2016