‘Smart Beta’ 5: No Alpha Here

May 02, 2014

 

  Number of Funds Significant Positive Alpha Significant Negative Alpha Percent Outperforming
One Year 193 2 2 1.0%
Three Years 128 4 4 3.1%
Five Years 118 7 3 5.9%

No matter where you look, or what statistics you use, these funds with catchy names and clever strategies are not working magic.

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 the above table.

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 off a smart-beta list. Risk-adjusted outperformance as a smart-beta criterion creates groups that are not acceptable to the ETF community, violating one of the ground rules I established.

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.

Using our ground rules, we’ve sent six of seven smart-beta criteria to the trash heap. The seventh, diversification, is quite simple to eviscerate.

The final criterion, “improves portfolio diversification,” will fail in the same way as alternative weighting, factor exposure and risk-adjusted outperformance. Requiring smart-beta funds to have a portfolio that is more diversified than a vanilla benchmark will create fund groups that also are not acceptable to the ETF community.

To measure the extent to which adding a fund to a portfolio increases diversity, we need to know what’s in the portfolio. I can’t know what you hold, dear reader, so I cannot speak to the consequences to your portfolio of adding any fund.

The best I can do is to measure concentration within self-proclaimed smart-beta portfolios.

 

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