Measuring Smart Beta ETF Performance

How have the largest and most established smart-beta ETFs performed compared with their cap-weighted counterparts?

There are many reasons investors may want to consider smart-beta ETF strategies in their portfolios. But perhaps the biggest reason is the most straightforward―the possibility of better returns.

That's the main selling point smart-beta ETF issuers use to market these products, and at least to some extent, the academic research backs them up.

That said, the research is clear: Not all smart-beta ETF strategies will outperform, and even for those that do, it’ll take a long enough investment time horizon to capture that potential outperformance.

It's in that context that readers should interpret the rest of this article, where we lay out the historical returns of various popular smart-beta ETFs compared to their market-cap-weighted counterparts. Just because a certain strategy is doing well or doing poorly in a particular arbitrary time frame doesn't mean it’ll continue to do so going forward: Factors perform and underperform in cycles.

Moreover, this article only contains a sampling of the plethora of smart-beta ETFs out there. These are among the most widely owned funds in the space with the largest amount of assets, but there are hundreds of others we don't touch on. Without further ado, here are the results ...

Value ETFs

Value ETFs are hands-down the most popular smart-beta ETFs. It helps that this factor is considered one of six that has historically outperformed the broader market over long time periods, according to MSCI research.

But the long time period the research measures and the shorter time period various value ETFs have been in existence are different, so it's no guarantee that ETF investors have seen this outperformance. Keep in mind each value ETF is different in the way it captures the factor. Some use price-to-earnings ratios, some use price-to-sales ratios, some use book values … the list goes on.

The iShares Russell 1000 Value ETF (IWD), with $37.3 billion in assets, the Vanguard Value Index Fund (VTV), with $30.4 billion in assets, and the iShares S&P 500 Value ETF (IVE), with $13.6 billion in assets, are the three largest U.S.-listed value ETFs today.

The below table includes the returns for these three funds since inception, along with the returns for their cap-weighted counterparts in the same time period:

As one can see from the table above, the time period measured and the ETF in question play a big part in determining whether a factor has outperformed or underperformed. IWD and IVE handily beat their cap-weighted counterparts since inception. But they were aided by the fact that their launches took place close to the peak of the dot-com bubble, when value stocks were relatively cheap and the broad market was filled with highly flying, overvalued tech stocks.

On the other hand, VTV, which didn't have that benefit when it launched in 2004, underperformed its cap-weighted counterpart since its inception. Again, the time period measured is key.

Growth & Dividend ETFs

After value, two of the most popular types of smart-beta ETFs are those that focus on growth and dividends.

Growth isn't one of the factors that academic research suggests tends to outperform over time, but that hasn't stopped billions of dollars from chasing it. On the other hand, dividend is a factor that is said to beat the broader market over time, but there's also been plenty of concern that such strategies may have become overvalued in today's low-yield world.

The iShares Russell 1000 Growth ETF (IWF), with $35.4 billion in assets, the Vanguard Growth Index Fund (VUG), with $26.5 billion in assets, and the iShares S&P 500 Growth ETF (IVW), with $17.5 billion in assets, are the three largest funds targeting the growth factor. Their returns are shown in the table below:

The returns for the three largest growth ETFs are the mirror-image of the situation with the value ETFs. IWF and IVW, which launched in 2000, sharply underperformed their cap-weighted counterparts as growth stocks struggled in the aftermath of the dot-com bust. However, VUG, which launched in 2004, outperformed.

In terms of dividend-focused ETFs, the Vanguard Dividend Appreciation Index Fund (VIG), with $23.9 billion in assets, the Vanguard High Dividend Yield Index Fund (VYM), with $17.8 billion in assets, the iShares Select Dividend ETF (DVY), with $17.2 billion in assets, and the SPDR S&P Dividend ETF (SDY), with $15.5 billion in assets are the largest funds in the pace. Their returns are shown in the table below.

Based on the returns for these four funds since inception, there's no clear evidence of either outperformance or underperformance for dividend smart-beta ETFs.

Other Factors
There are plenty of smart-beta ETFs other than those already mentioned that also target the value, growth and dividend factors. We've primarily looked at large-cap U.S. equity ETFs, but factor-weighting can and is applied to additional areas of the market, including mid- and small-caps, international equities and sectors.

Of course, there are also many more factors that ETF issuers can and do use to weight the holdings of a portfolio. According to MSCI, "a factor can be thought of as any characteristic relating a group of securities that is important in explaining their returns and risk." There are countless factors that can be isolated, although only a handful are thought of as having the potential to offer outperformance. Those are the ones ETF issues typically target.

Some others that fit this criteria are low size, low volatility, quality and momentum.

The $13.3 billion Guggenheim S&P 500 Equal Weight ETF (RSP) is a fund widely considered to be one that effectively targets the low size factor. By equally weighting its holdings, RSP has a much-smaller-cap tilt than a cap-weighted S&P 500 fund.

The $12.7 billion iShares Edge MSCI Min Vol USA ETF (USMV) and the $6.6 billion PowerShares S&P 500 Low Volatility Portfolio (SPLV) are the two largest funds targeting the low-volatility factor. The $3.7 billion iShares Edge MSCI USA Quality Factor ETF (QUAL) focuses on quality, and the $2.6 billion iShares Edge MSCI USA Momentum Factor ETF (MTUM) focus on momentum.

The table below includes the returns for these funds since inception, along with the returns for their cap-weighted counterparts in the same time period:

The standout among these funds is clearly RSP. Its tilt toward smaller companies helped it significantly outperform the market-cap-weighted S&P 500 in the period since 2003.