Thanks to a popular financial website, the term "alpha" has become popular over the past few years. Yet the ETF industry wants you to think a lot more about "beta."
Dozens of new exchange-traded funds were launched in 2013 in an emerging category known as "smart beta," and investors will be treated to many more of these ETFs in the coming year. It's a welcome development for an industry that risked growing stale.
While the term "alpha" refers to any gains an investor can reap above the broader market, beta refers to how a stock or fund should be expected to perform relative to a given benchmark.
In recent years, investors have had plenty of options among ETFs that can be expected to trade in a predictable fashion. From S&P 500 index funds to technology funds to high-yield bond funds, these passively managed ETFs are a great way to provide predictable exposure at a very low cost.
These ETFs have emerged as great values, especially in relation to higher-cost actively managed mutual funds, which can carry expense ratios exceeding 2%.
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Now, this new class of smart-beta ETFs -- which also go by terms such as fundamental ETFs, enhanced indexing ETFs or strategic beta ETFs -- aims to split the difference. These funds tend to adjust their portfolios with much more frequency than passively managed funds, promising nimbler performance in changing market conditions, and though they cost more than their passive rivals, their expense ratios rarely exceed 0.75%.
There are now more than 150 of these actively managed ETFs available, and dozens more are being lined up for launch in 2014. As a result, you'll want to track ETF industry developments to see where this dynamic category is headed.
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| Smart-beta ETFs have emerged as great values, especially in relation to higher-cost actively managed mutual funds, which can carry expense ratios exceeding 2%. |
How Smart-Beta ETFs Work
These funds often seek to replicate strategies used by hedge fund managers to gain a market edge. For example, Global X Top Guru Holdings Index ETF (NYSE: GURU), which was recently profiled by my colleague David Goodboy, holds stocks that are in favor with leading fund managers. Unlike passive ETFs, this ETF continually changes its asset mix. The 0.75% expense ratio is a bit higher than most ETFs, but this fund's 40% gain in 2013 beat the benchmark S&P 500 Index by a full 10 percentage points.
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There are a variety of these smart-beta ETFs, including funds that focus on general fundamental approaches, such as low price-to-earnings ratios (P/Es) or high-growth stocks; risk/volatility funds; contango/backwardation (that is, ETFs that focus on the rollover of short-term contracts); long-short spread funds; and funds focused on technical analysis.