Smart beta: How smart is it really?

In the exchange-traded fund (ETF) market, investors have for several years been finding an increasing number of products that deviate from the traditional market-weighted approach. We divide these «neo-ETFs» into two main categories: actively managed ETFs and smart-beta ETFs. Despite intensive marketing by the financial industry (active ETFs are more expensive and generally more profitable for providers), they have not yet been able to establish a dominant market position. Nevertheless, they are gaining popularity as portfolio satellites – that is, as targeted additions to an otherwise passively managed core portfolio.

• Smart-beta ETFs resemble active strategies but operate purely on a rule-based system using fixed mathematical formulas. Well-known examples include factor funds that specifically target value, momentum, or dividend stocks (you can learn more about these investment styles in this blog).
• Active ETFs, on the other hand, allow fund managers to make discretionary decisions – similar to traditional mutual funds.

Equal-weight ETFs play a special role. They are usually classified as passive investments but also exhibit characteristics of smart beta. The reason: Since they track a fixed, rule-based index (e.g., equal weighting of all stocks), they are classified as passive. However, because they deviate from the traditional weighting by market capitalization, they also embody the smart beta concept.

Smart beta is expensive

Smart beta products are, on average, about 0.2 percentage points more expensive than traditional ETFs. The reason lies in the extreme price competition among standard ETFs: While the annual management fees for the cheapest ETF tracking the Swiss SPI are just 0.09 percent, ETFs tracking the U.S. stock market are available starting at 0.02 percent. The costs for smart beta ETFs tracking U.S. stocks typically range between 0.2 and 0.6 percent.

The premium is even more pronounced for actively managed ETFs: Here, providers sometimes charge hefty fees, with a total expense ratio (TER) exceeding 1 percent being far from uncommon.

While the performance of certain of these specialized ETFs has been impressive in recent years and would have certainly justified the higher fees in some cases, investors should not overlook the fact that this excess return was achieved at the cost of higher risk or greater volatility. It’s like a horse race: some active ETF is always just a nose ahead. But the problem remains consistency – very few strategies manage to defend their lead over several years.

Higher Risk

The stocks of smaller companies generally fluctuate much more than those of industry giants, making them riskier. Many smart-beta ETFs are essentially small-cap strategies in disguise. The reason lies in the construction of these products, which is usually driven by the algorithms of a quantitative model. Let’s take the most illustrative example: equal weighting.

In a standard index, stocks are included in proportion to their market value (market capitalization). In the Swiss Market Index (SMI), which comprises 20 stocks, the dominance of the heavyweights is evident: Nestlé (as of March 2026) accounts for around 17.5 percent, followed by Roche with approximately 15 percent and Novartis with about 14 percent. UBS also occupies a significant position following its acquisition of Credit Suisse. At the lower end of the scale are companies such as Logitech and Sonova, which each account for less than two percent of this weight.

If these 20 stocks are now weighted equally, each company receives exactly five percent of the portfolio. Nestlé’s weight would thus be reduced to one-third, while the weight of a smaller index component would more than triple from 1.5 to five percent. «Equal weighting» may sound neutral, but it is not. On the contrary: it is a deliberate decision in favor of smaller companies within the index.

This may be intentional if one wishes to specifically capitalize on the momentum of smaller companies. A look at the U.S. market since 1926 seems to superficially confirm this outperformance: Small-caps delivered an annual return of about 11.8 percent, while large-caps averaged around 10.2 percent. However, this excess return is by no means linear – there are long periods during which the «big players» significantly outperform the small ones. The excess return was achieved at the cost of significant periods of below-average performance and higher volatility.

Long dry spells for rare sprints

Statistical averages suggest a consistency that does not exist in the markets. For example, the outperformance of smaller companies was not a consistent trend.

The data through 2026 illustrates the pattern: In about two-thirds of all years, small-cap stocks lag behind blue chips. The total return advantage over decades is often fueled by just a few extremely strong recovery phases – usually immediately after the market has bottomed out. Those who miss these brief windows are left with the higher costs and greater volatility.

This makes smart-beta strategies a psychological test of endurance. It requires iron discipline to remain loyal to a factor through years of underperformance while standard indices pull ahead.

Only passive investing is truly long-term

Successful investing is not a sprint, but a marathon. The credo of passive investing is: choose a strategy and stay the course.

Bad stock market years are stressful enough for the human psyche. At True Wealth, we make implementation as simple and transparent as possible. In efficient markets, there is no extra return without extra risk – even in 2026. The problem with many smart beta products is not the risk itself, but that it is cleverly concealed behind the «smart» label. Those who take on higher risks without realizing it are not acting smartly, but blindly.

• If you want to take on more risk for a potentially higher return, you can manage that specifically within your portfolio.
• There are no hidden bets.

So take a close look: With smart beta, it’s often just the risk that’s packaged smartly, not the strategy. Fund costs are a bit harder to hide these days. If they exceed 0.2 percent, it’s worth taking a closer look.

Links

• Actively managed ETFs: what you need to know
• The five best-known investment styles for equity portfolios

An earlier version of this article was published on November 2, 2016.