Smart beta funds are well established in the US, with $636 billion of assets under management, 10 times bigger than the equivalent European market. But these hybrid offerings are already gaining traction on this side of the Atlantic with professional advisers and investors – and we believe that where the US leads, the rest of the investing world will surely follow.
But are strategic beta funds – also known as smart beta – any good compared to plain vanilla ETFs? According to Morningstar’s head of passive fund research, Ben Johnson the short answer is No – although those tracking larger cap indexes perform better than funds following indexes of smaller-sized companies. His analysis chimes with the views of legendary Vanguard founder Jack Bogle, who gave a damning appraisal of strategic-beta funds in a Morningstar interview last year.
Strategic-beta exchange-traded funds track indexes that make active bets in an attempt to deliver better returns, less risk, or some combination of the two, as measured against a market-capitalisation weighted index. Beta refers to how closely a particular fund or stock tracks an index; most investors can track this simply in a low cost way. But others want funds that outperform the market without paying the higher costs associated with active fund management.
Johnson’s findings are worth noting for investors this side of the pond keen to tap into the boom in smart-beta ETFs. His analysis used nine categories and measured ETF fund performance against an equal-weighted benchmark of peers in the passive fund category – rather than one simple index.
He argues that this approach is more pragmatic as it stops fund managers cherry picking a favourable index to compare the fund’s performance against. For the purposes of calculating success rates, a strategic-beta ETF is considered to have succeeded if it survived to the end of the period and outperformed the equal-weighted composite of its cap-weighted counterparts.
Getting Strategic About Smart Beta Investing
Large-cap strategic-beta ETFs generally fared better relative to their mid- and small-cap peers: For the 10-year period ended March 31, 2017, 84% of large-cap strategic-beta ETFs outperformed their average market cap-weighted passive peer, while just 29% of their mid-cap and 33% of their small-cap counterparts managed the same feat. Johnson argues that the results may be skewed by the smaller sample size.
Investors have generally selected below-average performers from the menu of strategic-beta ETFs: In eight of nine categories, strategic-beta ETFs’ asset-weighted returns were less than their equal-weighted returns. This indicates that most of investors’ money has been plowed into funds that produced below-average results. On an asset-weighted basis, they outperformed in only two categories.
The survivorship rates are materially higher: than those for traditional actively managed funds. This difference is likely because this universe is much smaller, less saturated, and less mature than the market for active funds. “Survivorship” refers to whether a fund is still trading at the end of the period analysed. Many active funds are closed or merged with other funds after long periods of underperformance.
Greater risk has been taken on to improve performance: as Johnson notes – “the outperformance of strategic-beta ETFs in some categories may be at least partially attributable to the fact that they have, on average, assumed more risk.”
Almost all of the strategic-beta categories involve “value” investing: which aims to uncover undervalued shares. This means that the funds analysed are tilted towards toward cheaper and smaller stocks – which has been traditionally the preserve of active fund managers. Given that these were the poorest performing funds – 29% of midcap smart-beta funds outperformed their passive benchmark and 33% of small-cap managed to do so – UK investors may well want to search for smart beta funds with a large-cap bias.
In Conclusion?
Johnson argues that strategic-beta ETFs have “undeniable advantages over the majority of their actively managed peers”, as they attempt to combined the best attributes of active and passive approaches by outperforming the market at lower cost.
He says “the absence of idiosyncratic risk”, which strips out “the star fund manager” factor, is another key plus point. However, he concludes that these ETFs aren’t a clear improvement on their active counterparts: “All we can say for certain is that they will deliver a risk/return profile that differs from the market. So, like their active peers, they will experience cycles of relative out- and underperformance. Ultimately, whether or not investors reap the benefits of investing in these strategies depends on their ability to stick with them through thick and thin.”
So the lesson for UK investors is that they should choose carefully when attempting to surf the wave of smart-beta funds – and that a popular fund which attracts a lot of money is not more likely to outperform its rivals.
