‘Smart Beta’ Looks Like Expensive Beta

June 08, 2015

 

Once You Control For Risk ...

We’ll take two of the smart-beta ETFs with the longest track records: the Guggenheim S&P 500 Equal Weight ETF (RSP | A-84) and the PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-88). To assess performance of these actual investments, we’ll perform the simplest risk-adjusted test possible—testing for risk-adjusted outperformance after accounting for the risk exposure from a market-weighted investment.

 

If the smart-beta ETFs are successful at delivering better risk-adjusted returns, they will have a positive alpha coefficient in a regression. If they are just more volatile than the market-cap benchmark, they’ll have a beta greater than 1.

 

The results depicted below show zero improvement in volatility-adjusted returns, but a beta coefficient (risk-taking) of greater than 1.

 

 

 

Taking on more risk, on average, leads to higher returns. This is hardly outperformance. A consistent finding with smart-beta ETFs is that they take on more risk, not just different kinds of risk.

 

Their volatilities tend to be greater than their market-cap benchmarks, which must be controlled for when assessing performance. If the consumer could have achieved a similar result without a smart-beta fund by simply increasing risk (and saving higher costs), that would have been a preferable strategy.

 

But two examples—RSP and PRF—might not convince you.

 

Instead, take research conducted by Denys Glushkov, research director at Wharton Research Data Services, covering 164 smart-beta ETFs from 2003 to 2014. According to Denys:

 

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