Many investors still have misconceptions about exchange-traded funds (ETFs), including the type of market exposure they are getting with traditional capitalization-weighted ETFs. Dr. Chandra Seethamraju, director of systematic modeling, Franklin Templeton Solutions, gives us the lowdown on the concept of “beta” within ETFs—specifically strategic beta—and how it can offer a smarter investment approach.

Are you one of those people whose eyes glaze over when you hear the tem “strategic beta?” Well, stick with me today as I explain how it could totally transform the way you think about investing in exchange-traded funds (ETFs).

You may be thinking: Why do I need the lowdown on strategic beta? Well, what if I told you it could completely change the way you think about index funds? Better yet, what if I told you it may make you a smarter investor?

But before we start diving into strategic beta, let’s take a quick step back and talk about good old, regular beta.

What Exactly Is Beta?

In the world of investing, beta has traditionally been a measure of a security’s or portfolio’s volatility in comparison to the stock market as a whole. That leads us to a newer term that you might not know: cheap beta. If beta equals volatility, how can it be cheap—or expensive—for that matter?

Today, the word “beta” is also used as shorthand to describe getting broad stock-market exposure, typically through investments that often track the S&P 500 and other major indexes.

So, cheap beta refers to getting this exposure cheaply, for example, through exchange-traded funds (ETFs) that track indexes such as the S&P 500. But is that really a smart way to get broad exposure to the stock market?

These ETFs typically are market-capitalization weighted. Simply put, that means big companies automatically represent a bigger part of the portfolio, while smaller companies are a small—often even a tiny—part of the portfolio. Determining which companies represent the best value doesn’t even enter into the equation.

Not exactly rocket science!