PA ANALYSIS: Secret struggle of smart beta ETFs

Added 7th September 2017

Analysis by Morningstar's Alex Bryan has found many smart beta ETFs do not outperform straightforward index ETFs, raising doubts over the cost-effectiveness and use of the vehicles for investors.

PA ANALYSIS: Secret struggle of smart beta ETFs

In his report published on 30 August, Bryan, director at Morningstar, argued “it was possible to replicate most of [smart-beta fund] performance with a combination of market-cap-weighted indexes,” and that the fees these products charged were not justified. 

Smart beta products are often positioned as strategies that used to be the domain of active fund managers, but are now available in less expensive, algorithmically-managed products that sit in-between what are traditionally considered passive and active investing styles.

The fees they charge also tend to be higher than those of traditional market-cap-weighted index ETFs.

In his study, Bryan created replicate portfolios of Morningstar market-cap-weighted indices and found that they explained, on average, 92% of the return variance of US strategic-beta funds in the 10 years ending in May 2017.

“Most strategic-beta funds did not outpace their replicating portfolios,” he wrote.

Only 24% of the smart beta funds did better compared to these portfolios in the past five years. The 10-year result was more positive, with 42% – still less than half – outperforming the portfolios. 

“Most of these funds just repackage market risk, along with size and value exposures that simple cap-weighted indexes can offer"

After further analysis Bryant said: "Strategic-beta funds generally do not offer distinctive outperformance.”

Only one fund out of 65 in the 10-year sample had statistically significant alpha that could not be attributed to the market-cap-weighted indices. 

“Most of these funds just repackage market risk, along with size and value exposures that simple cap-weighted indexes can offer,” he wrote.

While the smart beta approach can pay off – a few funds Bryant measured delivered on their promise – on average it doesn’t, and investors shouldn’t pay fees that are higher than traditional ETFs.

Bryan’s approach was based on backward-looking analysis of fund and index performance.

As such, one has to take the conclusions with the usual caveat that what was true in the past may not be true in the future.

And even though it is theoretically possible to obtain the same exposure to factors using index funds as building blocks, Bryan admits that “it is more efficient to purchase a strategic-beta fund than trying to reassemble its factor exposures, which often shift over time”.

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