Benchmarking Smart Beta ETFs

Realized versus Theoretical Returns

March 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Long-only factor portfolios can be used for benchmarking smart beta ETFs
  • Results highlight minor tracking errors
  • Likely explained by relatively homogenous factor definitions by ETF issuers

INTRODUCTION

Investment professionals are not known for their creativity, but that is perhaps only because people outside of the finance industry do not understand the intricacies of finance. Significant amounts of creativity are required when creating investment strategies, explaining the daily ups and downs of the markets, or discussing why benchmarks are not really adequate in periods of underperformance.

Fund managers have a love-hate relationship with the latter as it weighs heavily on their career prospects. Although the purpose of benchmarking is to make investing more scientific by measuring the performance of fund managers, it is often a highly subjective process that requires the selection of peers or an index.

While a plain-vanilla large-cap U.S. equity manager can simply be benchmarked against the S&P 500, it is more questionable which benchmark is appropriate for measuring the performance of smart beta ETFs. These are supposed to provide exposure to common equity factors and definitions can vary across providers. In this short research note, we will benchmark smart beta ETFs in the U.S. against long-only factor portfolios based on factor definitions in line with academic research (try Finominal’s Alpha Analyzer for finding the best benchmark).

METHODOLOGY

We focus on five factors namely Value, Momentum, Low Volatility, Quality, and Growth in the U.S. stock market. The long-only factor portfolios are created by selecting the 30% stocks ranked most favorably by the factor and weight these by their market capitalization. The factor definitions are in line with academic research. Only stocks with a minimum market capitalization of $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.

SMART BETA UNIVERSE OVERVIEW

The theory of smart beta is based on factor investing literature, which highlights positive excess returns for a number of factors across asset classes an