6 Smart Rules for Using Today's Hottest ETFs

It used to be that investors who wanted better results than the market could deliver simply turned to actively managed funds. Yet trying to find a consistently good stock picker has proved exceedingly hard—only one in five has managed to beat the market over the past 10 years, because managers are, well, human and prone to cold spells.

Enter smart-beta funds and ETFs.

Backed by academic research and good old-fashioned marketing, the fund industry has launched more than 500 portfolios in recent years that offer investors a variety of new ways to try to outpace the market.

Unlike actively managed funds, smart-beta ETFs don't handpick the best stocks for any given moment. Instead, they hold baskets of stocks that tilt toward an attribute or "factor," such as low valuations and low volatility, that has been shown to outperform over time. (The term "beta" refers to the risks attributable to the market, so "smart beta" suggests a more intelligent way of constructing that market.) And because they're structured as index funds, smart-beta ETFs charge low fees, eliminating a big barrier to beating the market.

All this sounds great in theory. And the average smart-beta value fund that's been around for the past 15 years has beaten the S&P 500 by more than one percentage point annually.

But are these funds necessary? And how do you incorporate them into an existing portfolio? To answer that, Money gathered several industry experts at a MoneyShow conference at the New York Stock Exchange in November.

During that discussion, the panelists identified these six rules for using smart-beta ETFs.

RULE NO. 1

Smart beta should take the place of active funds

The issue: Because smart-beta ETFs are a type of index fund, conventional wisdom pits them against traditional index funds, such as the Vanguard 500, which buy and hold stocks based on their market capitalization. But if the point of smart beta is to outpace the market, shouldn't you compare these ETFs with actively managed funds?

The advice: "Why do people use smart beta?" asks Luciano Siracusano, chief investment strategist at WisdomTree, which manages smart-beta ETFs. "Why are they interested? I think it's the same aspiration for why people would use an active manager. Some are using it because they think they might be able to beat the market, which we should say is a very hard thing to do over a long period of time. If they're not happy with the active funds they've owned, that's an opportunity for smart beta."

The takeaway: There are several advantages to using smart-beta ETFs in place of an actively managed fund. "For people with actively managed portfolios, smart beta is sort of an opportunity to outperform but to do so in a more systematic way and at a lower cost," says Robert Nestor, head of smart-beta strategy at the ETF provider iShares.

The cost difference alone is striking. The average smart-beta ETF sports an annual expense ratio of just 0.66% of assets under management, half what actively managed stock funds charge on average.

RULE NO. 2

Walk, don't run, to these funds

The issue: Investors have plowed $132 billion into smart-beta funds and ETFs since the start of 2014, while equity funds in general have seen net redemptions. Yet history shows that chasing what's hot isn't an intelligent way to invest.

The advice: "Control your own behavior," says Ben Johnson, director of global ETF research at Morningstar. "Smart outcomes depend almost entirely on smart use. Smart beta is not super green algae. It's not as if we've created a super multivitamin that's going to go up when the rest of the market's going down.

"Also, there is a huge gap between the returns that funds produce and the returns that investors experience," he says. "It's not that investors pick bad funds. They just use them poorly. They buy high and sell low repeatedly."

Read next: The World's Best Mutual Funds and ETFs

The takeaway: Behavior matters. Take value investing, which is probably the most familiar smart-beta factor. Between 1991 and 2013, value-stock funds returned 9.4% a year, beating the 9% returns for the S&P 500, according to Research Affiliates. Yet during this same stretch, value-fund investors earned just 8.1% on average because they bought only after value came into favor and sold once the strategy turned cold rather than holding on for the long run.

Sadly, there are signs smart-beta investors are falling into the same old trap. "When we look at the data, 80%-plus of assets and 80%-plus of investors' new money over the past three years have gone into strategic-beta ETFs with a Morningstar rating of three stars or greater," Johnson adds, noting that star ratings are based on risk-adjusted past results relative to those of peers. (Morningstar says star ratings should be used only as a first step in evaluating a fund and should not dictate the funds to buy now.) "It's performance chasing 2.0."

RULE NO. 3

Tilt in moderation

The issue: Smart beta sounds great, but at last count there were more than 300 factors identified by various academics as capable of beating the market. Which should you choose and how do you fit them into a portfolio?

The advice: "There are hundreds of factors, but there are only a handful—about five—that have demonstrated what we would call reward over the long term," says Nestor. "There's value and low volatility. The other three that we've researched and that are supported by sustained academic evidence are high-quality stocks, momentum, and size," he adds, referring to shares of small companies with potential for growth.

But once you settle on a factor, don't let it overtake your existing strategy. "I would rarely recommend anyone dismantle their portfolio," Nestor says. "There are some obvious costs that you wouldn't want to trigger—most notably taxes, particularly after a roughly seven-year rally for stocks. But for those who feel like they want to step into smart beta, I would think about replacing maybe 10% or 20% of your primary asset allocation."

The takeaway: When in doubt, invest in the portfolio tilts you know, such as value, which favors beaten-down or overlooked stocks that trade at lower prices based on the company's underlying earnings, sales, or assets. Vanguard recently looked at various attributes and found that since 1926 a stock's price/earnings ratio has been the most predictive of future long-term performance, with low P/Es leading to high returns and vice versa.

Similarly, history has shown that over the very long term, you're better off investing in shares of budding small companies, which have returned 12.2% annually, over blue-chip stocks, which gained two percentage points less a year over time.

RULE NO. 4

Diversify Your Tilts

The issue: You may truly believe in a portfolio tilt toward, say, undervalued stocks. But if you're stuck in a period of underperformance like the 1990s, value investing can test your faith.

The advice: Don't hitch your entire portfolio to a single strategy. Siracusano notes that the smart-beta factors that generate excess returns "do it at different points in the economic cycle. It's like an oscillating wave. It's not as if every one of them is outperforming the market at the same time."

Nestor agrees. "The five factors that I think are most widely focused on by academics are highly cyclical," he says. "The issue for most of us is to be able to identify what part of the cycle we are in. There are some sophisticated investors that try to do that, but most people will combine a few factors that have low correlations to one another or will look to buy a recipe of sorts, which is what you see with the proliferation of multifactored strategies."

The takeaway: Diversification makes a lot of sense, but make sure you're combining factors that aren't correlated. The simple way to do that is through a multifactor ETF.

Read next: How to Strike a Balance With Bonds

If you're diversifying factors on your own, pair strategies like value and momentum, "which are kind of the peanut butter and jelly of factors," says Johnson. While value seeks out-of-favor stocks, momentum favors securities that have recently done well on the theory that successful investments have a tendency to outperform for a considerable time. "One tends to zig when the other zags, so when you put those two together, you smooth out those oscillations."

Another classic pairing is small stocks with high-quality shares. While small-company stocks tend to outperform the market in the first two-thirds of a bull-market cycle, high-quality stocks tend to do well in the final phase of a rally.

RULE NO. 5

Stick with your picks for at least a decade

The issue: While it's true that value stocks, small-company shares, and other portfolio tilts have historically outpaced the market, it's also true that those strategies can lag for years.

The advice: "If you want to invest in value, you've got to stick to value through thick and thin, and your time frame should be at a minimum 10 years," says Johnson. The same holds true for any other factor you want to take advantage of, be it high-quality companies with strong balance sheets or shares of small but rapidly growing companies.

"It's important to understand these anomalies you're looking to exploit," Johnson says. "What market environments will those particular factors fare well in? Which market environments will they fare poorly in?

Understand that those excess returns have shown up in the historical data, but they showed up over periods that are many multiples of most of our attention spans." Siracusano agrees: "These factors are generating excess return not each and every year, but over 30 years, 40 years, 50 years relative to the S&P."

The takeaway: Smart-beta funds are to be bought and held, not traded like a speculative stock. Case in point: Value funds frustratingly underperformed the rest of the market between 1989 and 1999. And while small stocks have beaten large ones by two points a year since 1926, they also underperformed blue-chip shares in the 1920s, 1950s, 1980s, and 1990s.

Another lesson: Smart beta isn't for everyone. If you're saving for a down payment on a home that's five years off or your kid's college tuition that's seven years away or if you're more than halfway into retirement, you won't have enough time to recover from these lulls.

RULE NO. 6

When in doubt, do nothing

The issue: For decades, investors who have relied simply on traditional low-cost index funds to match the market's returns have met their investment goals with little fuss. If you're in that camp, do you really need to incorporate this new strategy into your mix?

The advice: If you're interested in smart beta, "you should understand the investment case and you should feel confident in the underlying principles," says Nestor. "Or else stick with traditional market-cap-weighted indexing. You are always going to do great with the market-cap-weighted index in my mind if you hold it for long," he says. "You're going to outperform 70% and 80% of managers."

But not every investor is content with matching the market, Nestor adds. Some "are trying to manage some volatility, or they feel compelled to try to outperform, or they're at a point in their life that other factors, such as income, are really important. All three of those buckets are very neatly met by smart-beta approaches."

The takeaway: Don't get hung up on the term "smart." At Morningstar, they refer to these funds as strategic beta. "Yeah, there are some smart elements to it," says Johnson. But there are also smart elements to traditional index investing. And recognizing that may be the smartest thing you do.