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Get Smart About Smart Beta: Part 1

"Smart beta" has become an increasingly common Wall Street catch phrase, with a growing list of smart-beta products available to investors. But for many, it isn't always clear just what smart beta means.

A smart beta index is
essentially any index
that is based on measures
other than weighting
by market capitalization.

Investors pumped a record $6.42 billion into so-called "smart beta" equity exchange-traded funds (ETFs) and exchange-traded products (ETPs) in September 2017. And more than $53 billion has flowed into smart beta equity funds this year, according to ETF data provider ETFGI. Total assets invested in all smart beta equity ETFs and ETPs stood at $644 billion in the third quarter.

Since they are likely to stick around, now is a good time to get smart about smart beta products.

Let's start with something you're probably familiar with—index funds. These are mutual funds and ETFs that seek to track the performance of a particular benchmark index.

A few of the oldest and best-known indices that these funds track, including the Dow Jones Industrial Average, are price weighted. In other words, the higher the stock price of Company X, the more weight Company X has in determining the value of the index.

Most other widely known indices, including the S&P 500, NASDAQ 100 and Russell 2000, use a company's market capitalization to determine how much weight that particular stock will have in the index. Market cap is the company's share price multiplied by number of shares outstanding. So with a market-cap-weighted index, stocks with a higher market cap value account for a greater share of the overall value of the index.

Recently, there has been significant growth in the number of financial products, primarily ETFs, that are linked to and seek to track the performance of alternatively weighted indices. These indices are commonly referred to as "smart beta" indices. They are constructed using methodologies that rely on, for example, equal weighting of underlying component stocks, or measures such as volatility or earnings, rather than market-cap or price weighting.

A smart beta index is essentially any index that is based on measures other than weighting by market capitalization. Such indices might carry names like Strategic, Alternative, Advanced, Enhanced, or Scientific—labels meant to convey that something more than passive tracking of a market-weighted index is involved.

Get to Know a Smart Beta's Index

Not all smart-beta investments are created equal and for this reason it's particularly important before making an investment to understand what strategy or methodology went into the development of a smart beta product's tracking index.

Some smart beta strategies are relatively straightforward. For example, the companies in an equal-weighted index all have an equal representation in the index, regardless of market value. That typically results in smaller-cap companies having a bigger impact on the index than they would in a market-cap weighted index, and larger-cap companies having a relatively smaller impact.

Other smart beta indices can be based on more complex methodologies. There are products linked to fundamentally weighted indices, in which the index components are determined based on key company fundamentals including revenues, dividends or other corporate metrics.

A low-volatility strategy is another example of a smart beta index-weighting method. This strategy might measure the performance of the 100 least-volatile stocks in the S&P 500. In this scenario, the index components might be weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.

Still other offerings may be combinations of factors or exposures. A smart beta product will outline its strategies in the prospectus, a must-read for all prospective investors. It's also a good idea to visit the index provider's website to learn more about an offering's methodology.

While there are potential advantages to smart beta products, including diversification through exposure to nonmarket-cap weighted indexes, products tracking smart beta indices can also carry investment risks. Investors should be aware that returns for these products may be very different from investments that track market-cap-weighted indices.

Smart beta financial products may also have higher expenses. Those higher expenses might quickly eat up your returns. FINRA's Fund Analyzer can help you to understand fees by allowing you to compare over 18,000 mutual funds and ETPs.

Stay tuned for Part 2: Smart Questions to Ask About Smart Beta Products

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