Factor Scoring Smart Beta ETFs
Measuring the Value-for-Money Proposition of ETFs
January 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- The difference between the cheapest and most expensive smart beta ETF in the US is 59 bps on average
- Some smart beta ETFs offer negative factor exposure, which requires explanation
- Factor scores can be used to identify which smart beta ETFs offer the best ratio of factor exposure per dollar in fees
INTRODUCTION
Buying a Big Mac at McDonald’s in Basel, Switzerland, costs CHF6.50, compared with only CHF4.40 in Germany, which explains why the German McDonald’s locations close to the city are highly popular with Swiss nationals. Paying less for the same good is often worth the short drive across the border.
The same behaviour is observed in financial markets where investors typically choose the cheapest version when analyzing commodity-like products like indices. Somewhat unusual, investors have allocated $290 billion to the SPDR S&P 500 ETF Trust (SPY), which costs 5 basis points (bps) more than iShares Core S&P 500 ETF (IVV) and 6 bps more than the Vanguard S&P 500 ETF (VOO). Perhaps this is explained by SPY representing an extremely well-known ticker, which allows State Street, its issuer, to charge a premium that equates to approximately $100 million of fees per annum.
Further reasons might be that investors pay higher fees for better liquidity or simply consider the relatively minor fee differences marginal. However, although the price war in the ETF industry has reduced management fees significantly for many benchmark indices, there are still substantial differences in areas like smart beta.
We recently introduced the framework of factor scores, which measures the relationship between the factor exposure and expense ratio of a smart beta ETF. Our research note highlighted that Value-focused smart beta ETFs show a range of factor scores, some effectively representing better value-for-money propositions than others.
In this short research note, we will analyse the factor scores of the most popular smart beta strategies in the US.
SMART BETA ETFS IN THE US
We create our universe of smart beta ETFs in the US by selecting products that clearly include the factor in their name. Multi-factor products are required to provide exposure to at least three