How to Evaluate Smart Beta ETFs

Measuring the Factor Bang for the Buck

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

SUMMARY

  • Smart beta ETFs can be compared via a factor score, which relates fees to the factor exposure
  • Value-focused ETFs in the US show a wide range of factor scores
  • Large firms offer more attractive factor scores, but largely due to lower fees

INTRODUCTION

Beta is like ice cream and comes in many flavors. Broadly we can categorize it into the following four types:

  • Plain beta: Market capitalization-weighted benchmark indices like the S&P 500 or FTSE 100.
  • Smart beta: Indices with tilts to factors backed by academic and practitioner research. The most established factors in equities are Value, Size, Momentum, Low Volatility, and Quality.
  • Stupid beta: The inverse of smart beta. For example, if Growth is defined as selecting the most expensive stocks, then this does not constitute a particularly clever strategy given that it goes against decades of research.
  • Different beta: All other indices, e.g. stocks chosen on Catholic values. The excess returns of these indices are likely zero before costs and negative after costs on average, but such styles tend to align with personal values.

Equal-weight or fundamentally-weighted indices can be attributed to smart, stupid, or different beta, depending on the index construction.

Most investors are likely fully served by simply allocating to plain beta ETFs, but if achieving outperformance is a requirement, then smart beta is the only choice that has a solid foundation. However, smart beta ETFs are more expensive than plain beta ETFs and it is questionable if factor exposures are sufficient enough to offset the higher fees (read Smart Beta or Smart Marketing).

In this short research note, we introduce a framework for evaluating smart beta ETFs and use Value-focused products in the US as a case study.

SMART BETA FEES & FACTOR EXPOSURES

We define all Value-focused ETFs in the US as our universe and select these primarily based on the product featuring “Value” in its name. We exclude all ETFs that include other factors as we are only interested in pure Value strategies, which result