Illustrations by Yarek Waszul for MONEY
By Penelope Wang
June 3, 2016

Investing actively in mutual funds doesn’t just mean picking a fund manager. Nowadays there’s another option: So-called smart-beta index funds and ETFs can tilt your portfolio toward investing traits or “factors” that academic research has determined can do well over time. These factors include a focus on small-company stocks or shares trading at low valuations.

Smart-beta funds work much as index portfolios do—they follow a benchmark with a strict set of rules. But while proponents of smart-beta strategies often refer to them as index funds, these portfolios are more akin to an active investment approach because they have the same goal that fund managers do: to beat the market.

Understand the advantages

Smart-beta funds have one clear leg up on human-run funds. Because of their index structure, their costs tend to be low. The average expense ratio of a stock smart-beta fund is just 0.61%, less than half of what actively managed equity funds charge.

And because they aren’t run by people, smart-beta funds can’t deviate from their stated strategy—nor can the departure of a manager derail these funds. This explains why the strategy has caught on in a big way. Factor funds, as they’re sometimes called, are pulling in a lot of the money that has been flowing into passively managed portfolios.

Avoid the crowds

Hundreds of new smart-beta funds have launched recently, including those that tilt toward everything from low-volatility stocks to momentum, and even combinations of factors. As more investors pile in, many of the stocks these funds own are rising in price. The portfolio held by iShares MSCI USA Minimum Volatility Factor ETF, for instance, has a price/earnings ratio of 24.3, vs. about 19 for the broad market. Some dividend-paying stocks are also getting expensive. “There’s performance chasing going on right now, and as prices rise, the likelihood of earning a premium to the market diminishes,” says Larry Swedroe, director of research at Buckingham.

Graphic source: Morningstar

The better bet: Stick with tried-and-true tilts. Fortunately, some traditional factors have received less investor attention lately. Value stocks, for example, have underperformed growth-oriented shares for much of the past decade. As a result, iShares MSCI USA Value Factor ETF ISHARES TRUST EDGE MSCI USA VLUE FCTR ETF


VLUE
0.99%

carries a P/E of just 12.6. “The data show that tilting your portfolio toward value, especially small value stocks, improves your odds of beating the market if you hang on for a few decades,” says investment adviser William Bernstein, author of The Four Pillars of Investing.

Calculator: What is my risk tolerance?

For a small-cap value strategy, you can put a portion of that “explore” part of your portfolio into WisdomTree SmallCap Dividend WISDOMTREE TRUST US SMALLCAP DIVIDEND FUND


DES
0.18%

. The ETF, which is in the MONEY 50, tracks an index focusing on overlooked shares of dividend-paying small companies. It also sports an expense ratio of 0.38%, vs. 1.30% for the average small-cap value fund.

You’ve still got to do your part, though. You have to be willing to hang on to this type of fund for a couple of decades or more—perhaps until retirement. On the plus side, you won’t have to worry about the manager retiring before then.

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