The rise and fall of smart beta

There’s a reason why cap-weighted ETFs have been trouncing more strategic counterparts

The rise and fall of smart beta
According to theory and intuition, smart-beta strategies should be prime candidates for outperformance. But recent market reality hasn’t been bearing that out.

At least, that’s the case for smart-beta ETFs that use value-oriented weighting strategies, according to a recent article in the Wall Street Journal.

Citing data from Morningstar, the Journal said the broad category of strategic-beta funds was growing more than twice as fast as market-cap-weighted funds four years ago. Between July 2012 and July 2015, strategic beta’s share of index funds increased from 13.4% to 16.6%.

At the time, many individuals and advisors vouched for smart beta, insisting there was money to be made from alternative weightings. This claim was supported by Nobel laureate and University of Chicago finance professor Eugene Fama and Dartmouth College finance professor Kenneth French, who have shown that smaller and more value-oriented companies are rewarded with higher long-term expected returns for the risks they take.

But things have changed. While inflows for both cap-weighted funds and strategic-beta funds have accelerated year-on-year, cap-weighted funds have grown faster.

Recent data from Morningstar indicates that US$605 million went into cap-weighted funds over the two years ending July 31; during that same period, strategic beta collected US$117 billion. Strategic beta has also ceded some market share, now accounting for 16.2% of index funds.

This could be because smart-beta funds haven’t done as well as expected. Citing Ben Johnson, Morningstar’s director of global ETF research, the Journal said most strategic-beta ETFs have failed to deliver over the past one to three years.

“Aside from higher fees that can vary from a few percentage points to over 1% in rare cases, it turns out that large-cap growth stocks have far outpaced smaller and value-oriented segments of the US stock market,” the report said.

But the article pointed out that neither approach guarantees profit every year; in addition, both can provide low-cost diversification and tax-efficient portfolios. Regardless of strategy, problems usually occur when investors try to chase performance by following a hot strategy.

In the end, no matter what strategy one uses, it’s better to stay consistent rather than switching between two strategies based on recent returns. Waiting, in other words, is often more important than weightings.

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