‘Smart Beta’ Looks Like Expensive Beta

June 08, 2015

 

I find no evidence that SB [smart beta] ETFs significantly outperform their risk-adjusted passive benchmarks. Positive returns from intended factor bets are offset by negative returns from unintended factor bets resulting in an overall performance wash.

 

Risk-adjusted performance of SB funds is also insignificant when compared with the performance of the blended benchmark that provides passive cap-weighted exposure to market, size, and value factors. After decomposing benchmark-adjusted performance of SB funds into selection, static, and dynamic allocation effects, I find that their factor timing ability is neutral at best.

 

Issue 2: Higher (and hidden) costs to the consumer

While the higher expense ratios of these “active” index funds is clear, there are other hidden costs associated with investing in these funds. The first two derive from the higher transaction volume caused by a nonmarket-cap index.

 

Nonmarket-cap-based indexes have substantially higher transaction volumes because, to generate a chance of outperformance, they need to periodically re-deviate from their previous holdings. They do this both by selling out of some assets and buying into others. This exposes investors to transaction-based costs.

 

Liquidity Transaction Costs

Every market transaction exposes the fund (and its customers) to transaction costs such as the bid/ask spread. The more active a fund is, the more often it’s exposed to these transaction costs.

 

Market-cap index funds have built-in, transaction-minimizing features. As prices change, the funds’ holdings automatically match the market-cap-weighted allocations. The turnover required in a market-cap-weighted portfolio derives only from index inclusions and corporate actions, which are less frequent and less expensive.

 

Many active index funds have higher turnover due to the need to track the index in a way that often moves against market-cap weighting.

 

Tax Transaction Costs

These transactions (hopefully) will generate taxes in taxable accounts. Like other ’40 Act funds, ETFs pass through both the tax gains and losses to the end investors. As a result, while the pretax returns may beat a passive index, the after-tax returns may be significantly less than a more passively managed strategy in a taxable account.

 

In the case that the returns do not keep up with the passive strategy, the turnover can continue to reduce the end investor’s returns.

 

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