Most smart-beta ETFs performing worse than the market

A recent study suggests that smart-beta products aren’t built for the long term

Most smart-beta ETFs performing worse than the market
More and more ETF providers are coming out with smart-beta products, which use factor tilts like value and momentum to outperform indices for relatively low fees. While such strategies may be tempting alternatives plain-vanilla passives, one study suggests that they generally aren’t built for the long term.

Global financial firm UBS has found that smart-beta ETFs have mostly done worse than the overall market, especially when fees are taken into account, according to MarketWatch. Only 30% to 40% of smart-beta ETFs were found to beat their benchmark on an absolute basis; on a risk-adjusted basis, the percentage range went down to 25% to 32%.

Rates of outperformance were determined based on the time frame observed (ranging from 1 to 10 years), whether the returns are absolute or risk-adjusted, and what factor tilt is being applied.

“The median outperformance was lower than the median underperformance in each of the time frames analysed,” UBS said in a note to clients. “This indicates that, on average, the cost of choosing the ‘wrong’ ETF may be higher than the reward for choosing the ‘right’ one.”

On an absolute basis, 28.6% of value funds and 18.2% of momentum funds were determined to have beaten their benchmark over a 10-year period. On the bright side, 11 of 18 “size” funds studied (which are biased toward smaller funds) beat the market over the past decade.

One contributing factor is the uninterrupted bull run in the US stock market over the past 10 years, with a notable lack of corrections and volatility. Such an environment is more favourable for growth stocks than value stocks, and better for small stocks than large ones, which means growth- and size-tilted strategies have an advantage. Low-volatility funds would also struggle to beat the already low-volatility market.

“Factors have cycles. They will experience stretches of out- and underperformance relative to other factors as well as the broader market,” said Ben Johnson, director of global ETF research at Morningstar, wrote earlier this year. He also noted that such cycles “can be spurred by different fundamentals and will vary in length.”

Smart-beta products are nevertheless gaining traction. A late-May survey by FTSE Russell found 46% of asset owners have allocations to smart-beta indices, compared to 36% in the previous year. But the US$760.9 billion worth of assets in smart beta still doesn’t compare to the US$5.59 trillion in assets amassed by passive ETFs, as reflected in data from Morningstar.

Active funds are still the largest fund category, according to Morningstar, with US$9.83 trillion, though investors have been withdrawing from them generally. Around US$15.5 billion has been redeemed from active funds year-to-date, and multiple data points show that active funds are generally unable to outperform the market over long periods of time.

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