Deconstructing ‘Smart Beta’

August 21, 2014

 

It Gets Worse
Sharpe ratios, though aligned with alphas, tell an even more drastic story.

Not a single U.S. large-cap headline smart-beta fund produced a Sharpe ratio that’s statistically different from the benchmark—not in one year, three years or five years. That’s zero risk-adjusted outperformance for 11 headline smart-beta funds over the past five years, according to Sharpe ratios.

I wondered if things might be different outside of the U.S. large-cap segment, so I did a quick experiment.

Using ETF.com’s Fund Finder and Analytics tool, I searched for equity funds with names that contain words associated with self-proclaimed smart-beta strategies: alpha, achievers, beta, dividend, dynamic, earnings, equal, factor, fundamental (or RAFI), income, momentum, quality, revenue, volatility and yield.

I checked how many had statistically significant alpha against a segment-appropriate benchmark, at the 95 percent confidence level.

The answer: fewer than would be expected by chance (see Figure 5).

DeconstructingSmartBeta

While claims of risk-adjusted outperformance are probably the most reliable indicator of smart-beta funds, actual fund performance has been in line with risks taken—and for the past five years.

One small note: ETF.com’s Analytics system benchmarks high-yield dividend funds against MSCI’s High Dividend Yield indexes. This comparison yielded three of the four significant negative three-year alphas, and one of the three negative five-year alphas in Figure 5.

If actual risk-adjusted outperformance defines smart beta, then the smart-beta club will be exclusive indeed, with the vast majority of clever-sounding strategies barred at the gates.

Issuers who are applying smart-beta labels to their fund suites would surely object if they found those funds excluded from a smart-beta list. Therefore, risk-adjusted outperformance as a smart-beta criterion creates groups that are not acceptable to the ETF community.

In other words, risk-adjusted outperformance fails as a smart-beta criterion. Since risk-adjusted outperformance is what investors actually care about, it’s pretty much “game over” for the term “smart beta.” Time to say your goodbyes, because the end will be quick.

 

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