Smart-beta funds are alternative index funds that can be used strategically to outperform conventional index funds. But if used incorrectly, smart-beta funds can make an investor with even the best of intentions look not-so-smart.
In different words, finding the best smart-beta funds to buy is a matter of choosing the right tool for the right purpose.
The term “smart beta” can be a catch-all phrase for any indexing strategy that does not employ the cap-weighting techniques of conventional index funds, such as those that track the S&P 500 index. And because there are many different kinds of smart-beta funds, choosing the best one can be a daunting task.
For example, there are smart-beta funds that use equal-weighting techniques — where the fund’s holdings will allocate a substantially equal amount of portfolio assets to each security in the benchmark index — as opposed to the conventional cap-weighted allocation, where higher allocations are given to the securities with the higher market capitalizations.
To help make sense of the smart beta world, here are three of the best smart-beta funds, each with unique strategies to beat the market.
Best Smart-Beta Funds to Beat the Market: Guggenheim S&P 500 Equal Weight ETF (RSP)
Expenses: 0.40%, or $40 for every $10,000 invested
Investors wanting one of the best smart-beta funds that can beat the S&P 500 in the long run should take a look at Guggenheim S&P 500 Equal Weight ETF (RSP).
As this ETF’s name suggests, RSP owns all the stocks in the S&P 500 index but assigns equal-allocation weights to them. The end result is a higher relative allocation to the smaller-capitalization stocks in the index.
For example, top holdings in a conventional S&P 500 index fund will include mega-cap stocks like Apple Inc. (AAPL) and Microsoft Corporation (MSFT), whereas RSP gives equal weighting to lesser-known mid caps like Michael Kors Holdings LTD (KORS) and Cabot Oil & Gas Corporation (COG).
This equal weighting will typically provide market-beating long-term performance. For example RSP has a 10-year return of 7%, which compares to 6.5% on the S&P 500.
Investors should keep in mind that the added exposure to smaller-capitalization stocks increases market risk and can result in short-term performance below the S&P 500 during bear markets.
Best Smart-Beta Funds to Beat the Market: iShares MSCI USA Minimum Volatility (USMV)
Investors looking for the best smart-beta funds to beat the major indices tracking U.S. stocks during a bear market will like what they see in iShares MSCI USA Minimum Volatility (USMV).
USMV tracks the MSCI USA Minimum Volatility Index, which is comprised of stocks with low-volatility characteristics. Therefore, the portfolio is naturally tilted toward consumer defensive stocks, healthcare and utilities. Although the fund holds small- and mid-cap stocks, top holdings are large caps like AT&T Inc. (T), Public Storage (PSA) and Procter & Gamble Co (PG).
Since USMV was first made available to investors in 2011, there’s no bear market performance history. However, the fund handily beat the S&P 500 in 2014 and 2015. Year-to-date 2016, the fund is down only 1.4%, which is much better than the 5% price drop for the S&P 500.
Best Smart-Beta Funds to Beat the Market: First Trust Value Line Dividend (FVD)
Investors who like funds that can beat the S&P 500 while paying above-average dividends will be smart to check out First Trust Value Line Dividend (FVD).
FVD is an ETF that seeks to track the price and yield of the Value Line Dividend Index. This index narrows down to about 200 stocks from a universe of stocks that Value Line gives a “safety ranking” of 1 or 2. After further eliminating stocks not listed in the U.S., only those stocks with a higher-than-average dividend yield as compared to the S&P 500 index and a market capitalization of at least $1 billion make the final cut.
The holdings in FVD are equally weighted and rebalanced on a monthly basis. A few of those holdings, each of which are beating the S&P 500 in 2016, include Motorola Solutions Inc (MSI), Target Corporation (TGT) and Edison International (EIX).
Not only does FVD beat the S&P 500 year-to-date in 2016, it also wins in the one-, three-, five- and 10-year returns.
Of course smart investors know that past performance is no guarantee of future results, but the track records of our featured smart-beta funds at least demonstrate that these alternative index funds will be around for a while.
As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities. His No. 1 holding is his privately held investment advisory firm in Hilton Head Island, SC. Under no circumstances does this information represent a recommendation to buy or sell securities.