Shortcomings In Smart Beta ETFs

Did your ETFs own these few stocks that drove market performance?

The year 2020 was great for the U.S. stock market, and it surprised us all. The total return of the Wilshire 500 clocked in at 20.82%, including dividends. Two large ETFs that follow similar indexes had these returns:

• Vanguard Total Stock Market ETF (VTI)    21.03%
• iShares Core S&P Total U.S. Stock Market (ITOT)     20.71%

It’s an interesting exercise to put that performance in the context of underlying holdings, so I went looking for what companies drove these returns. Robert Waid, managing director at Wilshire, gave me the analysis.

Waid stated there were 3,463 stocks in the index as of the end of 2020. But a look at the top 20 drivers of this performance show how different stocks impact overall returns.

Below is a combination of the starting market capitalization of each of these 20 stocks and their 2020 performance. The results were as follows:

Apple, Amazon, Microsoft, Tesla and Alphabet were the top five contributors. Waid calculated that the 20.82% of the Wilshire 500 return would have only been 13.24% without these five stars.

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

That means that over a third of the return (36.4%, to be more precise) was due to about 0.14% of the constituents. Well over half of the return was due to these top 20 contributors, which represent about 0.6% of the constituents.

“From 2019 to 2020, the top 10 companies in the Wilshire 5000 remained virtually unchanged. The lone exception to this was, of course, Tesla, which ranked No. 6 for last year,” Waid said.  

S&P 500 funds, midcap funds and small cap funds didn’t own all of these top performers, at least for the full year. And smart beta ETFs may have owned these stocks, but weighted very differently.

“One of the beauties of a total market index is that you don’t need to pick winners, or time when to buy them, because, by definition, you already own them,” Waid explained. “By definition, a capitalization-weighted index is beta. Alternative-weighted indexes, such as smart beta, are taking active market bets.” 

Indeed, the FTSE RAFI US 3000 Index owned all of these stocks, yet returned less than half of the boring cap-weighted stock index at 9.3%. Smart beta indexes weight their holdings to outperform.

Takeaway

Over long periods of time, a very small number of stocks drive performance. A Vanguard study showed that, between 1987 and 2017, the Russell 3000 gained 2,100%, while the median stock gained only about 7%. A handful of stocks drove returns over that 31 years, which is similar to the findings from Wilshire Associates over the past few years.

Smart beta proponents argued that market-cap-weighted indexes were dumb because it was just buying too much of those overvalued large-cap growth stocks. Dumb beta is looking pretty smart now. That’s not to say that 2021’s top performers are likely to be the same as 2020s. If I knew that, I’d dump my total stock index funds and just buy those 10 or so stocks.

What I do know is that total stock index funds will own 2021’s top performers. Smart beta will outperform at some point, but making active bets has a low probability of success, especially when it’s combined with higher fees.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.