• Wealth Management

A Smart Approach to Smart Beta ETFs

Smart Beta funds have taken the ETF market by storm. The right perspective—and some smart questions—can help you make use of them.

It's hard to escape the commentary swirling around Smart Beta ETFs lately.

Interest in Smart Beta, which shares attributes with both actively and passively managed funds, has ramped up steadily in recent years. But depending on the headline of the day, they are either the new golden investment tickets or merely hype.

Michael Jabara, who leads Morgan Stanley Wealth Management's ETF and closed-end fund research, says the reality is more nuanced: “These investments are something that you should have in your tool kit, but you need to do your homework."

Indeed, Smart Beta ETFs can provide some benefits, including the potential for returns when traditional, market cap-weighted funds are floundering. But investors need to be savvy about the Smart Beta vehicles they're considering—and dig into why these ETFs are called “smart”—before pulling the trigger.

Smart Beta Basics

Traditional index-linked ETFs rely on market capitalization to determine how much of each security they hold, so the larger the company, the more of the fund it accounts for. However, many contend that such a simplified approach leaves investors overexposed to big brands when their stock prices are high—and less able to capitalize on smaller companies that may be more attractively valued.

Apple is an easy example. Earlier in 2016, several tech-focused ETFs took a hit when Apple’s stock took a tumble. Because of Apple’s large market cap, the weighting had an outsized effect on the performance of those funds.

Smart Beta strategies take a different approach by tracking indices that weight securities by factors other than market capitalization. They often seek to generate returns by stressing a specific factor or factors and appropriating holdings accordingly. For instance, a Smart Beta fund might weight company holdings based on dividends, earnings, value, potential for growth or any other subset of factors.

“They have attributes of passive management in that they track an index, but they're also like active management in that they're trying to beat it," says Jabara, whose group was recently recognized in March of 2016 by Capital Link for “Best ETF Research Team” for the fifth consecutive year.1

Mixed Performance

Smart Beta funds have been the belle of the ETF ball for the past several years. Their assets stand at $250 billion, a five-fold increase since 2010, and the number of funds has surged to more than 400.2 But popularity doesn't necessarily equate to performance.

To be sure, the hybrid model of passive and active management presents an appealing potential for alpha inside a relatively lower-cost ETF. Yet Smart Beta funds may also be conceived with biases that could work against you.

Source: Morgan Stanley Wealth Management ETF Research, Bloomberg. Data as of 7/10/2015

“There are so many different types of Smart Beta strategies that can be beneficial, but you can also end up concentrating your risk in areas that are out of favor,” Jabara says.

Smart Beta returns are as varied as the strategies themselves. Morgan Stanley compared the performance of large-cap Smart Beta strategies to an S&P 500 ETF over a three-year annualized return period. The results: Half of the Smart Beta ETFs beat the traditional ETF, while the other half underperformed.

Part of Your Tool Kit

So what should investors make of Smart Beta strategies? While they can be a good addition to your core portfolio, Jabara argues that for most of us, they shouldn't be much more than that—an addition. “We don't suggest that these replace your core active or passive holdings, but instead we recommend using Smart Beta ETFs as satellite holdings," he says.

However, before you invest, you need to do your research. “They're all different from each other and at the end of the day, you want to know as much as you can about the strategy," he says.

For example, investors should ask:

  • What factor(s) or strategy is the ETF emphasizing?
  • What are the valuations of the underlying constituents of the ETF?
  • What environments does the fund do better in, or worse?
  • What is the fee?
  • How liquid is the product?
  • How well does it track its index?
  • Will it be around in six months?

Admittedly, “they're a bit more challenging to understand than a traditional ETF," says Jabara. Your best bet is to dive into specific Smart Beta strategies—compare them and investigate their costs. You may find a welcome complement to your more-traditional investments.

For more information on Smart Beta ETFs, talk with your Morgan Stanley Financial Advisor or find one here. Your Financial Advisor can walk you through Smart Beta ETF approaches and how they might fit into your broader portfolio strategy.


There is no assurance that performance will be enhanced or risk will be reduced by pursuing a “smart beta” strategy. Investment factors that may lead to outperformance against an index may also entail additional or unique risks not associated with that index. Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. ETFs which pursue this strategy often incur greater internal trading costs than traditional index-tracking ETFs, and may trade at an execution price further away from their underlying net asset value than traditional index-tracking ETFs

Please consider the investment objectives, risks, charges and expenses of the fund(s) carefully before investing. The prospectus contains this and other information about the fund(s). To obtain a prospectus, contact your financial advisor. Please read the prospectus carefully before investing.

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