Smart Beta & Factor Correlations to the S&P 500
Diversification Is Difficult
August 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Most smart beta products exhibit correlations of > 0.9 to the S&P 500
- Factors show correlations of zero on average
- However, factor correlations are highly volatile across the market cycle
INTRODUCTION
In our recent research note “Smart Beta vs Factors in Portfolio Construction” we analysed the impact of including Value & Growth smart beta ETFs in an equity-centric portfolio and concluded that there was no improvement in returns or decrease in drawdowns, compared to an improvement in the risk-return ratio when using Value & Growth factor exposures. Naturally Value and Growth are only two of many factors and investors face an abundance of smart beta products. However, the question remains if any of these offer diversification benefits, which is one of the few free lunches in the investment world. In this short research note we will focus on the correlations of various smart beta products and factors to the S&P 500.
METHODOLOGY
We’re going to focus on the S&P 500 and the following smart beta strategies: Value, Growth, Quality, Momentum, Low Volatility, and Dividend Yield. All smart beta ETFs have AUM of larger than $500m and many have a long trading history. We calculate the performance for all factors by creating long-short portfolios comprised of the top and bottom 30% of the US stock universe. The portfolios are constructed beta-neutral and include 10bps of transaction costs. It’s worth mentioning that we don’t cover Dividend Yield as a factor, but will be showing correlations as it’s a popular smart beta category. The table below shows the smart beta ETFs used in the analysis.
