Many exchange-traded funds (ETFs) have their holdings weighted by market capitalization. In other words, the total market value of a company’s shares determines what proportion of an ETF’s assets are invested in that holding. But “smart beta” funds are different, since they are not market-cap weighted.
For example, the market-cap-weighted SPDR S&P 500 (SPY), an S&P 500 ETF, has as its top two holdings Apple (AAPL), 3.36%, and Exxon Mobil (XOM), 2.47%. Apple is a bigger company than Exxon Mobil, so it has proportionally more representation in SPY’s holdings.
Although “smart beta” funds also follow a passive index like other ETFs, the smart beta funds do so in ways besides the traditional market-cap-weighted approach.
There are several different ways a smart beta fund can be structured to avoid following the market-cap-weighted method. The most basic approach is to weight all stocks in an index equally, instead of by market cap. Another way is to weight the stocks in an index based on different fundamentals, such as book value, cash flow, sales or dividends. There are not really many limits on approaches smart beta funds can use; any number of other factors, like volatility, can be used to determine how much of a fund’s assets are put into each holding.
As an example, let’s compare SPY with the Guggenheim S&P 500 Equal Weight ETF (RSP), a smart beta fund that puts an equal weighting on each stock in the S&P 500. SPY has gained 8.62% this year, while RSP has done better, with an increase of 9.49%. RSP also has a yield of 1.37%. The chart below compares the performance of these two S&P 500 funds during the last year.
“Smart beta” has been gaining prominence among investors, but many individuals still do not know all the details about these funds. My hope is that this ETF Talk has served to demystify the concept of smart beta funds, and you now feel comfortable looking further into these nontraditional ETFs.
If you want my advice about buying and selling specific ETFs, including appropriate stop losses, please consider subscribing to my Successful ETF Investing newsletter. As always, I am happy to answer any of your questions about ETFs, so do not hesitate to send me an e-mail. You just may see your question answered in a future ETF Talk.
In case you missed it, I encourage you to read my article from last week about leveraged Russia ETFs. I also invite you to share your thoughts below.