Swedroe: Do ETFs Harvest Factors & Shrink Premiums?

March 31, 2017

Similarly, ETFs focusing on the utilities and consumer staples have high exposure to the low volatility factor, as do high-dividend ETFs. On the other hand, biotech, information technology and energy all had large negative exposures to this factor.

Blitz’s sample consists of all U.S.-listed ETFs that invest in U.S. equities and that have at least 36 months of return history as of December 2015. This amounts to 415 distinct funds with combined assets under management of more than $1.2 trillion, about 5% of the entire U.S. equity market.

ETFs With Large Positive & Negative Exposure

He analyzed the factor exposures of these ETFs and found that “for each factor there are not only funds which offer a large positive exposure, but also funds which offer a large negative exposure towards that factor.”

He also found: “On aggregate, all factor exposures turn out to be close to zero [ranging from -0.03 to 0.03], and plain market exposure is all that remains. This finding argues against the notion that factor premiums are rapidly being arbitraged away by ETF investors and also against the related concern that factor strategies are becoming ‘overcrowded trades.”

Blitz found that the so-called smart-beta ETFs have positive exposures toward the size, value, momentum and low-volatility factors, with the largest and most significant exposure being toward the size factor. That must mean that the conventional ETFs have significant negative exposures toward the size and value factors. And that is just what he found.

‘Betting Against Each Other’

He concluded: “These results imply that, from a factor investing perspective, smart-beta ETFs tend to provide the right factor exposures, while conventional ETFs tend to be on the other side of the trade with the wrong factor exposures. In other words, these two groups of investors are essentially betting against each other.”

Blitz also concluded that while investors looking only at the tens of billions of dollars in smart-beta ETFs may be concerned about the sustainability of the low-volatility premium going forward due to overcrowding, the funds in question only represent a small fraction of the total ETF market. Looking at the other end of the spectrum, it turns out there are a similar number of funds that provide the exact opposite factor exposure. Looking at the entire ETF market, the net exposure toward the smart-beta factors is indistinguishable from zero.

These results imply that ETF investors, on aggregate, are not arbitraging the premiums away or making the trades overcrowded.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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