What Are Smart Beta ETFs?

As we like to do here at The Juice, today’s installment builds on a couple that came before it. 

To understand smart beta ETFs, it helps to consider some prerequisites. That said, while the name “smart beta” makes it sound like we’re going to talk about something super complicated, we’re not. Smart beta ETFs are pretty straightforward. 

At least investing in them is. Constructing them, not so much. 

In fact, if you look at today’s Trackstar list of the smart beta ETFs investors have been searching for most across the platforms of our 100+ financial media partners, you’ll see some familiar names. You might own a smart beta ETF without even knowing that’s how it’s characterized. 

Not super complicated, but still important. 

Because the Schwab US Dividend Equity ETF (SCHD) is number one in Trackstar today, we’ll go to Charles Schwab for the definition of a smart beta ETF. Plus we know you sometimes don’t like to hear only The Juice talk! 

So, Schwab says: 

Smart beta ETFs (exchange-traded funds) screen and weight securities based on factors other than market capitalization. 

Most of the major indexes (e.g., S&P 500 Index, Russell 1000 Index, Russell 2000 Index, MSCI EAFE Index) are market-cap weighted, meaning that the largest companies have the largest weight in the underlying index. Smart beta or strategic beta represents a different way of constructing the index basket. Popular strategic beta strategies include equal weighting, fundamental weighting, minimum variance, and low volatility.

Fair and easy enough. And, in a minute, we’ll use SHCD to illustrate how a smart beta ETF can function. 

First, the background. 

You might buy a smart beta ETF — and, more so, index and fund families make them available — to help diversify your portfolio. As we note in this Juice on diversification, we believe in a “A More Diverse View Of Diversification.” 

In that, it’s not enough to just own a bunch of individual stocks in different sectors. Or a bunch of names or ETFs under one approach. You need to thoughtfully mix individual holdings alongside a set of different strategies and approaches. Smart beta ETFs can help you do this. 

Maybe the most straightforward type of smart beta ETF is an equal-weight ETF, mentioned by Schwab above, and methodically defined and illustrated late last year by The Juice:

As the name implies, equal-weight ETFs hold the stocks of whatever index they track in equal proportion. Not based on market cap.

When you own, say, the SPDR S&P 500 ETF (SPY) and Invesco QQQ ETF (QQQ), you’re going to be significantly overweight stocks such as Apple (AAPL) and Microsoft (MSFT) because the indexes SPY and QQQ track hold stocks based on market capitalization. 

But there’s also the slightly more complicated smart beta ETF style that’s common. One where an ETF still tracks an index, but it’s an index that isn’t based solely, or at all, on market cap. 

SCHD is a good example. However, you don’t see any mention of SCHD being a smart beta ETF in Schwab’s marketing. This is, in part, because Schwab isn’t doing the “smart beta-ing.” It passively follows the Dow Jones U.S. Dividend 100 Index. 

This index screens the broader Dow Jones U.S. Broad Stock Market Index, excluding REITs, and then selects dividend stocks from it based on the following criteria, pulled directly from the website of S&P Global, which owns, constructs and manages the index:

Stocks must pass the following screens:

• Minimum 10 consecutive years of dividend payments

• Minimum FMC of US$ 500 million

• Minimum three-month ADVT of US$ 2 million

Stocks passing all three screens are ranked in descending order by IAD (indicated annual dividend) yield, defined as a stock’s IAD (not including any special dividends) divided by its price. The top half of securities based on this ranking are eligible for stock selection.

From there, the stocks go through a super rigorous — and equally as complicated — process to form the final index. No stock can hold more than 4% weight. 

So, what we have here is a passive ETF — SCHD — that tracks what is technically a passive index that is — and here’s the key — actively constructed. 

We covered this dynamic a bit more in Should You Be Buying Dividend Stocks?

There’s nothing wrong with any of this. It’s just to say that an equal-weight index doesn’t have many decisions to make. But the Dow Jones U.S. Dividend 100 Index that SCHD tracks really goes deep in constructing a very specific type of dividend index. 

In Thursday’s Juice we’ll dig into some of these names as we look under the hood of some smart beta ETFs. 

The Bottom Line: It’s nice to know the method behind the madness. Not always necessary, but nice to know. 

If nothing else, when you hear the name smart beta ETF thrown around, at least you’ll know what they’re talking about on, say, CNBC. 

We’re geeks here at The Juice. So we find it fascinating to really dig into the on-the-ground meaning of passive versus active ETF investing. 

If you know a geek who might like The Juice, forward them today’s installment and ask them to sign up for free.

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