Smart Beta Is Not The Golden Ticket

You can produce the smart beta effect through a combination of small cap and large cap ETFs - for lesser cost

etf
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Reviewed by: Alan Miller
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Edited by: Alan Miller

"Smart beta" may sound like investment nirvana but it comes with a catch: some of the more successful smart beta ETFs' recent gains appear to be thanks to an inherent bias to smaller and medium-sized stocks. As with all investments, you need to conduct robust due diligence.

A year ago, we selected a new, higher dividend, smaller company-focused European smart beta ETF as a superior replacement for our "old fashioned" market cap-weighted ETF of the same asset class. However, since we switched, the smart vs the not-so-smart's performance has been almost identical, even though their underlying stocks and their weightings are different. Over the longest period of data available, the market cap-weighted European small cap ETF has marginally outperformed the smart beta smaller cap, higher dividend ETF after fees (19.2 percent versus 18.5 percent).

Source: SCM Direct.com

I continually question whether many smart beta ETFs are too concentrated and inherently volatile compared to their market cap-weighted counterparts. Smart beta seems to necessitate an element of timing to ensure that your chosen so-called 'smart factor' is not being bought at its relative peak.

One golden rule is to look closely at the underlying make-up and valuation of the smart beta index constituents before jumping in.

The problem with analysing a UK sample of smart beta ETFs is that many of these funds do not have a very long track record.

I conducted an analysis of the various equity (non-sector) smart beta ETFs listed in sterling and traded on the London Stock Exchange. I compared their performance with a conventional market cap-weighted index from the end of 2014 to last Friday's close (23rd October 2015). I used the most comparable MSCI or FTSE alternative to represent the equivalent market cap return index.

Source: SCM Direct.com

This chart above shows that the spread of returns is pretty significant and many clients might not have the appetite to cope with the significant chance of underperforming by 5 percent plus in any given year.

To reduce this downside risk, investors might combine smart beta with market cap-weighted indexes or combine more risk factors in their portfolios.

 

Higher Cost

In our sample of 44 smart beta equity ETFs, the average cost as measured by their total expense ratios was 0.48 percent – more than double a typical market cap-weighted ETF. In addition, the average underperformance of these smart beta ETFs vs their market cap-weighted equivalent index was minus 1 percent. Clearly, 2015 has not been a great year for smart beta.

The five best performing ETFs in our sample were as follows:

Name of ETF

Market Cap Index used in comparison

2015 YTD ETF Return

2015 YTD Market Cap Index Return

 

2015 YTD Smart Beta Outperformance

 

FIRST TRUST UNITED KINGDOM

FTSE All Share

11.29

2.92

8.37

OSSIAM ETF FTSE 100 MINIMUM

FTSE 100

7.24

1.56

5.68

ISHARES UK DIVIDEND

FTSE All Share

8.56

2.92

5.64

AMUNDI ETF FTSE UK DIVIDEND

FTSE All Share

7.95

2.92

5.03

LYXOR SG EUR QUALITY INC

MSCI EMU

8.81

5.00

3.81

 

However, some of the outperformance of the better performing smart beta ETFs has been a direct result of the market cap bias of their smart indexes.

So far in 2015, the mid cap UK FTSE 250 has outperformed the large cap FTSE 100 by just over 8 percent and it is interesting that the First Trust ETF above has circa 35 percent invested in mid-caps and the IShares UK Dividend around 24 percent invested in mid-caps vs a market cap index weight of just 8 percent. Similarly, the Lyxor European Quality ETF has 28 percent invested in mid-caps vs a market cap index weight of just 1 percent.

In terms of the worst performing smart beta ETFs so far in 2015, there was no single explanation. Whilst some of these ETFs relied on the value factor tilt – 2015 has been one of the worst years for some time for value vs growth stocks – others included socially responsible investing, U.S. large cap, U.S. minimum variance and emerging markets income stocks.

Smart beta investing requires just as much analysis as any other type of ETF. Investors need to carefully analyse each ETF for evidence of sector or company bias and compare the resulting valuations against its market cap-weighted counterpart.

In many cases, a cheap, small cap ETF in a particular market will capture the same effect as a smart beta ETF. By combining such ETFs with even cheaper large cap ETFs, investors can reduce overall cost and volatility against a market cap benchmark or a pure smart beta portfolio. As with all investments, there are no guarantees, and even with smart beta ETFs, don't assume you've just won the gold ticket.

 

 

 

Alan Miller is chief investment officer at specialist ETF  asset manager SCM Direct.com