US equity investors might be better off getting their smart beta wholesale, or rather via a simple do-it-yourself strategy.
That’s the contention of a new research paper which studied the performance of 164 domestic equity smart beta ETFs from 2003 to 2014.
Carried out by Denys Glushkov of the University of Pennsylvania, the study found “no evidence” that smart beta funds can significantly beat their risk-adjusted passive investment benchmarks.
Smart beta, which has enjoyed phenomenal success in attractive assets, is a strategy which tries to improve on index tracking returns by adjusting away from the typical cap-weighted style, in which a given fund will hold shares or securities in proportion to market capitalization. Instead, smart beta funds tilt their portfolios to strategies such as value and momentum, which managers argue can generate positive long-term risk- premiums.
Growth in the smart beta complex has been extremely rapid. True smart beta ETFs now account for roughly US$220bn, or about a tenth of all assets in domestic US ETFs. Other estimates put the overall assets under management of smart beta strategies at north of US$500bn.
But those assets are paying a cost to access smart beta strategies. While less expensive than many traditional active management products, smart beta, which essentially tweaks standard index investing to try and capture extra return in areas with record of outperforming, charges a premium.
On Glushkov’s calculations smart beta ETFs are charging 70% more than standard ETFs, or with an asset-weighted expense ratio of about 41bp. That would imply US$370m in extra fees a year. Every year.
So, are smart beta funds worth it?
“Positive returns from intended factor bets are offset by negative returns from unintended factor bets resulting in an overall performance wash,” Glushkov writes. Factor bets are allocations to stock characteristics like momentum or value. This is not to say that there is no outperformance, only that the evidence of any isn’t strong and similar results can be cobbled together more cheaply.
Do-it-yourself?
Over the more than decade the study covered, data shows that nine of the 15 categories of smart beta funds beat their benchmarks, by an average of 1.31 percentage points annually. The other six underperformed, but by 2.26 percentage points per year. In the most recent year, only equal-weighted, risk-weighted and volatility smart beta funds beat their benchmark. Indeed, when you look at one popular risk measure, Jenson alpha, only value smart beta funds beat their benchmark by statistically meaningful amounts.
This jibes with earlier criticism of smart beta by James Montier of GMO, who has essentially deemed it a smart way to market existing strategies like value and small capitalization, rather than a revolutionary tactic.
One of the other common marketing points for smart beta is that it can do well in all types of markets, with strategies like dividend and volatility-based doing well on a raw basis even in down markets. Sadly none of the smart beta categories studies beat their risk-adjusted benchmarks during market downdrafts.
One of the most telling parts of the study is where the risk-adjusted showing of smart beta funds is compared to a fairly simple benchmark which gives investors passive capitalization-weighted exposure to market, size and value strategies.
Smart beta ETFs in the sample charged between 18bp a year for growth and value type investments all the way up to a chunky 75bp a year for more complex strategies, such as one which pick stocks based on quant rankings or broker recommendations. The passive cap-weighted blended strategy, in contrast, costs less than 7bp a year.
None of this, of course, is to say that the next decade won’t be different, and that smart beta won’t outperform more convincingly. That’s possible, and it is also possible that some managers do it better than the smart beta sector as a whole.
Still, investors may not find those better managers, or those that are better may not stay better.
On the whole, investors might be able to do it themselves and pocket a large amount of that US$370m in annual fees.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
