Here’s a way to look beyond typical index funds.
The rise of index funds has been undeniably beneficial to smaller and less sophisticated investors. In decades past, you either had to have a high investing IQ or very deep pockets to tap into certain corners of the market, but now you can easily find a low-cost exchange-traded fund to fit your needs. Recent innovations have provided even more sophisticated options, too, known as “smart beta” ETFs that allow for tactical trading or a more targeted approach to your portfolio. The greek letter beta is used in finance to describe volatility or variance from a given benchmark, so smart beta funds are ETFs that use a straightforward, rule-based system to distinguish themselves slightly from the more vanilla benchmarks with which you might be most familiar. These funds offer investors a way to look beyond the usual suspects to give you more control and input into your portfolio’s makeup — with the built-in ease of ETFs.
Vanguard Growth ETF (ticker: VUG)
Perhaps the most obvious example of a smart beta ETF, this roughly $80 billion exchange-traded fund from investment giant Vanguard takes a very simple approach to differentiate itself from the typical S&P 500 fund. Basically, VUG sorts the largest U.S. stocks by metrics like sales growth or earnings momentum and then takes the top 300 or so and leaves the rest. Perhaps unsurprisingly that means a bit more tech stocks — 46% of the entire VUG portfolio compared with 27% or so in the S&P 500 — and almost no stocks in sleepy sectors like utilities. It’s not particularly complicated, but it can be effective; consider that over the last five years VUG has gained about 150% compared with just 100% or so for the conventional S&P 500.
Vanguard Value ETF (VTV)
The natural complement to the prior Vanguard fund is VTV, a value-oriented ETF that instead biases investors toward the less dynamic but more stable parts of Wall Street. Consider that tech stocks make up a mere 7% or so of this smart beta ETF, with top sectors instead being financials at about 25% and health care at 18% of the fund. This makes sense, given that these kinds of companies tend to rank better for value metrics including book value and operating cash flow, but it also obviously means you’re making a conscious decision to ease off more aggressive investments. And for the record, those aggressive growth-oriented plays have significantly outperformed; in contrast to VUG, VTV is up only 65% or so in the last five years to significantly lag the S&P 500 in the same period. Value may return to favor at some point, but this track record shows the downside of a smart beta ETF that is out of step with trends.
iShares MSCI USA Min Vol Factor ETF (USMV)
Taking a different approach, this iShares fund is not looking to layer on screening for growth or value but rather works more generally to reduce the overall volatility of the portfolio with a purely defensive approach. That may mean you leave a bit of money on the table when a bull market is raging, but it could theoretically protect you from deeper losses if and when Wall Street hits a snag. Again, the names that make up this ETF will likely be very familiar — such as Microsoft Corp. (MSFT) and Johnson & Johnson (JNJ) — but it’s the weighting that makes all the difference. Consider that in the S&P 500 right now, consumer staples stocks only make up about 6% of the index. By contrast, USMV has a nearly 11% weighting in this sector thanks to its lower risk profile. With about $28 billion in total assets, this fund’s low-volatility approach has caught on with many investors lately even if it has meant giving up some growth potential.
Schwab U.S. Dividend Equity ETF (SCHD)
Another very popular smart beta ETF is this Schwab fund that takes the typical list of U.S. stocks and filters it according to metrics that are important to income-oriented investors. It’s elegantly simple: Rank large-cap U.S. stocks on the quality and sustainability of their dividends, then take the top 100 names from that list. These include names like tech company IBM (IBM), which just tallied its 25th consecutive year of increasing dividends and has paid some form of distribution to shareholders uninterrupted for more than a century. This fund isn’t just one of the most popular smart beta ETFs out there because of this approach, but it’s also one of the largest on all of Wall Street with an impressive $25 billion in total assets under management.
Invesco S&P 500 Equal Weight ETF (RSP)
What if the filter you’re looking to apply to the stock market isn’t about picking favorites at all, but rather about ensuring a more balanced approach? If this sounds appealing, look no further than RSP — an “equal weight” fund that looks to avoid relying too much on one single stock in the S&P 500. In the age of trillion-dollar tech companies, it’s perhaps not surprising that some funds are overly reliant on these megacap stocks. And in fact, the standard S&P 500 index fund has about 15% of total assets in the trio of Apple (AAPL), Amazon.com (AMZN) and Microsoft alone. RSP looks to avoid all that with a target weighting of about 0.2% for each of the 500 or so stocks in the fund and regular rebalancing to keep things in line. Granted, you may not like this if AAPL goes on a tear while being on equal footing with stocks like railroad operator Kansas City Southern (KSU), but for investors who prioritize diversification, this smart beta ETF could be worth a look.
ProShares Large Cap Core Plus ETF (CSM)
Formed in 2009, this ProShares fund is one of the oldest smart beta or “multifactor” funds on Wall Street. It also has a great track record, outperforming the S&P 500 benchmark since inception. The process is fairly simple: Start with the 500 largest U.S. corporations in the S&P, score them across 10 different factors including growth and value metrics, then optimize the portfolio once a month to overweight the highest-scoring large-cap stocks and actually bet against the lowest-scoring large-cap stocks. The list of top holdings is familiar, led by Big Tech darlings like Facebook (FB) and Alphabet (GOOG, GOOGL), but that’s the name of the game with smart beta ETFs. You’re not getting a big shift away from the typical S&P 500 index fund, just a slightly different makeup based on the screening methodology. And based on the fact CSM is up 16% this year compared with about 13% for the S&P, that methodology may have something to it.
iShares ESG Aware MSCI USA ETF (ESGU)
With all the focus on sustainability and social justice lately, it’s important to keep in mind that smart beta ETFs aren’t always constructed with a straightforward goal of outperforming a given benchmark. In the case of this iShares fund, the extra factors layered on top are designed to invest in companies that prioritize ESG — that is, environmental impact, social responsibility and governance of their corporate board. Specifically, ESGU has picked about 350 large and midsized U.S. stocks that rank better than their peers in these areas, such as electric vehicle maker Tesla (TSLA). This fund is one of the largest ESG-focused options on Wall Street right now with about $17 billion in assets. It’s worth noting that ESGU has slightly outperformed the broader S&P 500 in the last 12 months — proving you can invest with a conscience and still grow your nest egg with this smart beta ETF.
Seven smart beta ETFs to buy now:
— Vanguard Growth ETF (VUG)
— Vanguard Value ETF (VTV)
— iShares MSCI USA Min Vol Factor ETF (USMV)
— Schwab U.S. Dividend Equity ETF (SCHD)
— Invesco S&P 500 Equal Weight ETF (RSP)
— ProShares Large Cap Core Plus ETF (CSM)
— iShares ESG Aware MSCI USA ETF (ESGU)
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Update 06/02/21: This story was published at an earlier date and has been updated with new information.