Smart Beta ETFs Bridge the Gap Between Active and Passive

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When stepping into the investment markets, investors usually consider either actively managed funds backed by a team of experts or passive products that simply track a benchmark index. However, with smart beta exchange traded funds, investors can do both.

"The strategic/smart beta category has grown rapidly for its potential to deliver on the coveted benefits of skilled active management, primarily alpha1 generation and risk reduction, but in a wrapper that also has some of the attractive attributes of passive approaches, not the least of which are low relative costs," according to a Victory Capital research paper titled, Life isn't binary. Neither is your portfolio.

Strategic beta or smart beta refers to a group of indices and tries to provide an alternative to traditional market-cap weighting methodologies, often incorporating investment styles traditionally associated with actively managed funds.

As investors consider various active or passive strategies, they may look to three primary drivers of investments, including return, risk and costs. This potential combination is the lure of strategic beta and the reason for its soaring popularity, according to Victory Capital.

“Strategic beta provides a disciplined, active-like approach to indexing in a cost-effective manner, and it does a good job at balancing those three legs of the stool,” Mannik S. Dhillon, President of VictoryShares and Solutions with Victory Capital, said in the research paper. “It allows for transparent exposure to a portfolio of preferred factors and intuitive tilts. And as a strategic tool, I think it can enhance a passive allocation and counterbalance some of the inherent biases and other limitations of cap-weighted indexing, while striving to deliver alpha at lower costs than active strategies.”

Specifically, many are concerned about the indirect risks associated with top heavy, market cap-weighted index funds, especially in a prolonged bull market environment where the the largest component company stocks within these cap-weighted indices are also the priciest top performers.

Consequently, these rules-based, smart beta strategies are seen as a good alternative as they incorporate fundamental or alternative weighting methodologies to limit risks and potentially enhance returns, much like how active managers try to generate alpha.

“It’s active intuition with passive delivery,” Dhillon added.

Victory Capital also offers its own suite of smart beta ETFs that focus on volatility-based weighting methodology to potentially help investors generate improved risk-adjusted returns. For instance, the VictoryShares US 500 Enhanced Volatility Wtd ETF (CFO), VictoryShares US EQ Income Enhanced Volatility Wtd ETF (CDC) and VictoryShares US 500 Volatility Wtd ETF (CFA) start with the broad market and screens for companies with four quarters of positive earnings. Those stocks are then weighted based on their standard deviation over the past 180 trading days. Stocks with lower volatility are given higher weightings and stocks with greater volatility are given lower weightings. Ultimately, all securities that pass the earnings criteria are present, just at different weights.

For more on smart beta ETFs, visit our Smart Beta Channel.

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