Smart beta ETFs experienced a record year for inflows and remain a popular ETF category. While they may serve a role in portfolios, smart beta ETFs require careful due diligence: ETFs tracking the same investment factor (e.g., value) can perform differently based on how they define and measure the factor.

Although smart beta ETFs are designed to incorporate elements of both active and passive management, we believe they aren’t a substitute for the flexibility of a truly active approach.

What are smart beta ETFs?

“Smart beta” can be broadly defined as any index-based strategy that doesn’t use traditional market-capitalization weighting. Many smart beta ETFs tilt to investment factors such as value, momentum and quality.

Within ETFs, smart beta is a popular category that gathered a record $139 billion in 2022, with dividend ETFs accounting for nearly $70 billion of those inflows.¹

Smart beta ETFs are often marketed as “quantitative active” with the claim that they combine the best features of active and passive index-based strategies. However, we believe these strategies are no substitute for active managers with a proven process.

We also think that investors may underestimate how seemingly small differences in the methodologies of smart beta ETFs can lead to big differences in investment results. Here are five things to understand about smart beta ETFs.

1. Don’t judge a book by its cover

We believe one common mistake investors make with factor-based ETFs is assuming that all value, momentum or other individual factor ETFs perform similarly. In reality, small differences in index methodology can lead to different returns and portfolio concentration.

Value is a well-known factor and may provide a good example. Value stocks are generally seen as those trading below intrinsic value. But it’s important to understand exactly how valuation is measured.

Let’s examine two indexes for U.S. large-cap value stocks: the Russell 1000 Value Index and S&P 500 Value Index. The S&P 500 Value Index uses the ratios of book value, earnings and sales to price. Meanwhile, the Russell 1000 Value Index uses price-to-book ratio, consensus forecasts and sales-per-share historical growth.

For the year ended February 28, 2022, the Russell 1000 Value Index had a negative total return of 2.8%², while the S&P 500 Value Index had a positive return of 1.5% over the same period.³ Clearly, ETFs tracking the same factor can deliver different results. That’s why factor-based ETFs typically require more due diligence than ETFs tracking plain-vanilla indexes that weight stocks by market cap. 

2. Look out for sector concentration and style mismatches

Speaking of due diligence, one of the first things to check with a factor-based ETF is if it has any limits on how large individual sectors can get. Some smart beta ETFs don’t have sector guardrails — instead, they go wherever the factor takes them. As a result, factor ETFs may become concentrated in individual sectors and exhibit big swings in sector allocations when the factor index rebalances.

For example, at the end of February, the MSCI USA Momentum SR Variant Index had 35.2% in health care and 25.3% in energy ‒ or more than 60% in the two sectors.⁴ Because some investors associate momentum with growth stocks, they may be surprised that the index’s largest sector is a traditionally defensive sector: health care.

Momentum is a factor based on the expectation that stocks that have outperformed recently will continue to do so. Therefore, momentum ETFs are based on indexes that identify stocks with the best recent performance, for instance over the trailing 12 months.

Investors in momentum ETFs, therefore, should pay attention to index rebalances when sector allocations can shift dramatically, particularly in volatile markets with regime changes in sector leadership.

3. Check turnover

ETFs that track market-cap-weighted indexes generally have had low turnover in the underlying constituents. Factor indexes can be a different story, though. For example, the MSCI USA Momentum SR Variant Index had turnover of about 44% for the year ended February 28, 2023.⁴

The ETF structure can help limit capital gains distributions resulting from the higher turnover of smart beta and actively managed ETFs. Still, investors shouldn’t assume that a factor-based ETF will have low turnover just because it tracks an index.

4. Understand how a factor is measured

As discussed earlier, there is no single, straightforward method for determining a stock’s valuation. For example, value indexes may compare a stock’s price against earnings, sales or book value. Some may even use forward-looking estimates. Another issue is how to incorporate intangible assets that aren’t captured in earnings or the balance sheet, such as brand equity and intellectual property.

Dividend ETFs, which saw record inflows last year, are another example of the importance of understanding the details. Some dividend ETFs may simply target stocks with the highest yields, but this can add risk because of potential exposure to distressed companies. Other dividend ETFs focus on companies that have a long history of consistently raising their dividends, which may result in lower yields in return for higher-quality companies.

From a sector perspective, dividend ETFs may also have higher allocations to traditional dividend-paying sectors like utilities and financials. Indeed, at the end of February, the Dow Jones U.S. Select Dividend Index had 24.3% and 22.3% in utilities and financials, respectively, or nearly half in the top-two sectors.³

5. Be mindful of investor behavior and factor timing

Individual factors can stay out of favor for long periods of time. From a behavioral perspective, that can challenge investors to be patient enough to reap the potential outperformance of a particular factor.

Multi-factor ETFs appear to be a solution to this issue, but combining several factors may result in them simply canceling each other out, leaving the investor with what amounts to a traditional index fund. Multi-factor ETFs add another layer of complexity and due diligence, because investors must understand not only how they individual factors are measured, but also which factors are included and how they’re combined.

Finally, there is the possibility that the rising popularity of factor-based investing has turned it into a “crowded trade” and that future outperformance may be more elusive. For example, academic research examining the period 2000–2018 found that smart beta indexes tended to perform worse after an ETF was launched based on them.⁵ In other words, smart beta indexes’ outperformance “on paper” in back-tested results didn’t tend to persist after an ETF was launched based on the strategy, and the shortfall may be due to data mining in the construction of smart beta indexes.

The case for active ETFs over smart beta

We believe two common mistakes with smart beta strategies are thinking all factor ETFs are created equal and assuming they can replace active management.

At Capital Group, our active objective-oriented ETFs seek better investment outcomes in a variety of markets. Although we may incorporate factor-based research into our investment approach, we then go much deeper. Our investments are grounded in proprietary, fundamental research that gives us deep knowledge of a company from top to bottom.

Explore our suite of actively managed equity and fixed income ETFs.

¹ Morningstar, as of December 31, 2022.

² FTSE Russell, as of February 28, 2023.

³ S&P Dow Jones Indices, as of February 28, 2023.

⁴ MSCI, as of February 28, 2023.

⁵ “The Smart Beta Mirage.” Shiyang Huang, Yang Song and Hong Xiang, June 9, 2020. Study sample is representative, covering about 80% of the total AUM of the U.S. equity smart beta ETFs classified by Morningstar.