Why smart-beta funds may not be so special

A new study suggests that smart-beta fund performance isn’t so difficult to replicate

Why smart-beta funds may not be so special
As the investment-fund market becomes increasingly saturated, many providers are coming out with smart-beta funds, which are presented as differentiated strategies that therefore deserve higher fees. But according to a new study, some of those funds may not be so innovative.

“[M]any of these funds simply overweight smaller and/or cheaper stocks, and investors could obtain these tilts more directly with market-cap-weighted index funds,” said Alex Bryan, director of passive strategies research for North America at Morningstar.

To see whether investors can replicate strategic-beta fund performance using market-cap-weighted indexes, Bryan took a sample of strategic-beta equity funds and divided them into three geographical classifications (US, foreign developed markets, and emerging markets). He examined funds that were listed in Morningstar’s database at the beginning of June 2007 and at the beginning of 2012.

For each geographical region, he created portfolios of market-cap index funds meant to replicate six different styles. The performance of the strategic-beta funds was then compared to the performance of an appropriate corresponding portfolio over a five-year and 10-year period.

“The replicating portfolios fit the return patterns of the strategic-beta funds well,” Bryan said. “On average, the replicating portfolios explained 92% of the return variance of the US strategic-beta funds during the trailing 10 years through May 2017.”

Over a five-year period, portfolios accounted for an average of 87.85% of US equity portfolios’ performance; 89.14% of foreign equity funds’ performance; and diversified emerging-market funds’ performance.

“The fit was high for most of these funds because they did not distinguish themselves through security selection, portfolio rebalancing, or timing the size or value factors,” he said. “[T]raditional market risk, size, and value/growth tilts could explain most of their performance.”

Bryan did an additional statistical analysis to determine if the strategic-beta funds offered performance beyond repackaging market, size, and value exposures. “This analysis indicates that strategic-beta funds generally do not offer distinctive outperformance,” he said. “In other words, the funds that did out- or underperform their replicating portfolios did so largely because of differences in their exposure to the market, value, and size factors.”

While the study showed many smart-beta funds aren’t as distinctive as advertised, Bryan clarified that many strategic-beta funds are still worth investing in. Often, their exposures to different factors shift over time, making it difficult to reassemble them exactly using a mix of cap-weighted funds, and a large minority of funds did manage to outdo their corresponding portfolios.

“However, investors shouldn't pay significantly higher fees for these strategies than market-cap-weighted alternatives, which capture the same performance drivers and can replicate most of their returns,” he said.

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