Investors looking to beat the market often find themselves sifting through a variety of different funds, each purporting to deliver the secret sauce that leads to outperformance.
However, a long-standing reality is that a large majority of these funds do not outpace their benchmark indexes, especially when viewed over extended periods.
According to the recent S&P Indices Versus Active, or SPIVA report, a significant 92.2% of all U.S. large-cap funds trailed the S&P 500 over the past 15 years through June 30, 2023.
The underperformance can be largely chalked up to the pitfalls of active management. High fees which eat into potential returns, excessive turnover that can incur more transaction costs and “closet indexing,” where managers claim active management but merely mimic a benchmark, are among the prime culprits.
Recognizing these challenges, several investment managers have introduced a middle ground: so-called “smart beta” exchange-traded funds, or ETFs. The name itself offers insight into its philosophy.
Where passive indexing, sometimes termed “dumb beta,” targets only market risk exposure, smart beta goes a step further, selectively zeroing in on additional factors to potentially harness greater returns.
These funds are not your traditional indexed offerings, nor are they fully reliant on the discretion of active managers. Instead, they sit somewhere in between as a hybrid.
Smart beta ETFs may follow a specialized index that applies filters for metrics like return on equity, price-to-book ratio, earnings per share growth and dividend yield.
Alternatively, some of these ETFs rely on a firm’s in-house, rules-based approach to focus on factors that research has shown to influence long-term investment returns. Factors like value, size, momentum, quality and low volatility come to the forefront in such strategies.
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A great example of a dedicated firm offering smart beta strategies is Avantis Investors, which currently operates a suite of 24 ETFs.
“Our goal is to systemize active management and offer portfolios with all the advantages of indexing, such as broad diversification, low turnover, low expense ratios [and] high tax efficiency, but without its disadvantages,” says Daniel Ong, senior portfolio manager at Avantis Investors.
Matthew Dubin, portfolio manager at Avantis Investors, agrees with Ong, adding: “Unlike index strategies, which are forced to hold securities for a subjective time based on a predefined reconstitution date, our strategies are managed daily so investment decisions are based on current market and company information to enhance expected returns.”
That being said, smart beta ETFs aren’t just found at Avantis. Numerous other firms, including Dimensional Fund Advisors, Invesco Ltd. (ticker: IVZ), BlackRock Inc.’s (BLK) iShares, Charles Schwab Corp. (SCHW), Vanguard and more all feature smart beta ETFs in their lineup.
Here are seven of the best smart beta ETFs to buy now:
| ETF | Expense Ratio |
| Dimensional U.S. High Profitability ETF (DUHP) | 0.21% |
| First Trust Capital Strength ETF (FTCS) | 0.55% |
| VanEck Morningstar Wide Moat ETF (MOAT) | 0.46% |
| Invesco S&P 500 Low Volatility ETF (SPLV) | 0.25% |
| Avantis U.S. Equity ETF (AVUS) | 0.15% |
| Avantis All Equity Markets ETF (AVGE) | 0.23% |
| Avantis Moderate Allocation ETF (AVMA) | 0.21% |
Dimensional U.S. High Profitability ETF (DUHP)
Investors often find allure in the meteoric returns that speculative “junky” stocks can offer in the short term, but they can be highly risky. For those seeking a long-term, buy-and-hold approach, zeroing in on stocks marked by robust profitability is preferable. All else being equal, the Fama-French factor research found that companies with robust profitability historically perform better than those without.
DUHP employs a systematic, rules-driven methodology to identify U.S. stocks with high earnings relative to their assets or book value. The ETF also checks for price-to-cash-flow and price-to-earnings to ensure holdings are not overvalued. Its rigorous process ensures portfolio turnover stays relatively low at just 2%. DUHP currently charges a 0.21% expense ratio.
First Trust Capital Strength ETF (FTCS)
FTCS tracks the unique Capital Strength Index, which as its name suggests targets companies with solid fundamentals in the form of strong balance sheets, steady earnings growth, robust profit margins and historically low volatility. The index starts by selecting the largest 500 stocks in the broader Nasdaq U.S. Benchmark Index and filtering them for sufficient trading volume.
Then, the index removes companies that do not have at least a war chest of $1 billion in cash or equivalents, a long-term debt-to-market-cap ratio under 30% and a return on equity higher than 15%. The remaining companies are ranked based on their three-month and one-year realized volatility, and the 50 lowest ones are selected for inclusion. FTCS charges a 0.55% expense ratio.
VanEck Morningstar Wide Moat ETF (MOAT)
MOAT has distinguished itself in the smart beta ETF realm, outpacing the S&P 500 since its launch with a 13.7% return, compared to the S&P’s 12.6%. Central to MOAT’s strategy is Morningstar’s unique quantitative approach, focusing on stocks that are both undervalued and possess what’s termed a “wide moat,” which they define as a “sustainable competitive advantage.”
According to Morningstar, this advantage can originate from various factors, including intangible assets, a distinct cost advantage, effective scale, high switching costs for customers and a robust network effect. However, MOAT’s methodology also screens for attractive valuations, to ensure that the ETF is not overpaying for wide-moat stocks. MOAT charges a 0.46% expense ratio.
Invesco S&P 500 Low Volatility ETF (SPLV)
Most investors operate on the belief that there’s a trade-off between risk and reward — typically, a higher potential return demands a willingness to shoulder a greater risk. However, the “low volatility anomaly” suggests that, paradoxically, stocks with less price fluctuation have historically produced better risk-adjusted returns than their more volatile counterparts.
Investors who believe in the low volatility anomaly can use a smart beta ETF like SPLV to target it. This ETF tracks the S&P 500 Low Volatility Index, which holds 100 S&P 500 stocks that have displayed the lowest volatility over the previous year. Consequently, SPLV’s holdings lean toward defensive sectors, such as consumer staples, health care and utilities. The ETF charges a 0.25% expense ratio.
Avantis U.S. Equity ETF (AVUS)
“Our equity portfolios tend to emphasize companies with higher cash profitability and that are trading at an attractive price-to-book ratio,” Dubin says. “These valuation metrics have been well documented in cutting edge research as indicators of higher expected returns.” To give a portfolio core holding a smart beta tilt, investors can use an ETF like AVUS, which screens for both metrics mentioned by Dubin.
AVUS currently has a composition similar to regular index ETFs that track the broad U.S. stock market, with higher sector representation in technology stocks and finance names. Its top holdings contain the same companies seen in the S&P 500, such as Apple Inc. (AAPL), Microsoft Corp. (MSFT) and Amazon.com Inc. (AMZN), but in lower proportions. The ETF charges a 0.15% expense ratio.
Avantis All Equity Markets ETF (AVGE)
AVUS has a U.S.-centric focus, which can be limiting in terms of diversification. A viable alternative is AVGE, which includes international stocks. “AVGE provides a one-stop shop for global equity investments, investing in 11 underlying Avantis ETFs that provide exposure to approximately 10,000 companies in 43 countries at a very attractive 0.23% expense ratio,” Ong says.
Notably, AVGE’s underlying holdings offer exposure to small-cap value stocks, which has historically been a very potent factor combination with market-beating returns. “AVGE places a special emphasis on companies trading at attractive pricing with good cash profitability, including small-cap companies with attractive valuations, to increase expected returns,” Ong says.
Avantis Moderate Allocation ETF (AVMA)
More risk-averse investors may find AVGE’s 100% equity allocation too volatile for their tolerance. A viable alternative here is AVMA, which includes some bonds. “AVMA provides a holistic asset allocation in one ETF for investors with a moderate risk profile by investing approximately 70% of its assets in global equities and 30% in investment-grade fixed income,” Dubin says.
As with AVGE, AVMA utilizes a tax-efficient and balanced “ETF of ETFs” structure to provide its exposure to global small-cap value. “To achieve its broadly diversified asset allocation, AVMA invests in 12 underlying Avantis ETFs that provide exposure to more than 10,000 equity and fixed-income securities across 43 countries,” Dubin says. The ETF charges a 0.21% expense ratio.
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7 Smart Beta ETFs to Buy Now originally appeared on usnews.com
Update 10/30/23: This story was previously published at an earlier date and has been updated with new information.
