Measuring True Costs Of ‘Smart Beta’ ETFs

April 27, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments. For more on 'smart beta' ETFs, see our Smart Beta Channel.

 

The concept of systematically alternatively weighting an established index has been around for many years, as evidenced by the success of mutual funds from Dimensional Fund Advisors.

 

In the world of ETFs, this alternative-weighting concept has come to be known as “smart beta,” and represents one of the fastest-growing segments of the ETF marketplace.  Many investors are skeptical of this trend and regard “smart beta” as simply a marketing term. 

 

At Toroso, we believe that the root of this skepticism stems from the lack of understandable evaluation metrics. We believe one unique data point that can be isolated for smart-beta ETFs is the true cost of the “active share,” which I’ll define below.

 

Finding The Elusive Metric

How can investors analyze the “real” cost of smart beta?

 

We look to identify a static metric, which can be used to evaluate the merits of the alternative index weightings. We accomplish this by identifying the overlap of the smart-beta ETF to the traditional market-cap-weighted index as a benchmark. Then we apply the difference in expense ratio to the unique portion known as the active share or “smart component” in the world of passive indexing.

 

The table below compares the five largest “smart beta” ETFs focused on U.S. large-cap equities. This list, with assets under management (AUM), includes:

 

 

 

They are all compared with the S&P 500, represented by the iShares Core S&P 500 ETF (IVV | A-99), which has an annual expense ratio of 0 .07 percent, or $7 for each $10,000 invested.

 

The most important column is labeled “Effective Expense Ratio of Smart Component,” because that illuminates the true cost for the portion, which can’t be purchased through the benchmark. 

 

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