Smart Beta or Smart Marketing

The Unusual Choices of Evidence-based Investors.

April 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Smart beta ETF investors seem to ignore empirical evidence
  • Excess returns from smart beta are substantially different from factor returns
  • Smart beta ETFs offer little diversification for an equity-centric portfolio

INTRODUCTION

Assets under management in smart beta products surpassed $1 trillion in 2017, according to Morningstar. That was three years earlier than predicted by BlackRock, the single largest issuer of smart-beta exchange-traded funds (ETFs).

Investors have not only embraced smart-beta products, which are long-only portfolios with factor tilts, but also allocated billions to long-short factor products. However, despite the enthusiasm shown for smart-beta ETFs, several concerns remain about the products and how investors are using them (read Smart Beta vs Factor Returns).

This article addresses four key challenges of smart-beta products:

• First, the difference between investor interests and empirical evidence
• Second, the gulf between simplicity and complexity
• Third, the gap between realised versus expected returns
• Finally, the difference between investors’ objectives and product characteristics

INVESTOR INTERESTS VERSUS EMPIRICAL EVIDENCE

Smart beta is based on factor investing, which has its foundation in the work of Eugene Fama and Kenneth French. In a seminal 1993 paper they explained equity returns in terms of market risk in combination with the Value and Size factors. Since then, their work has been replicated across time, countries and various asset classes. Other factors such as Momentum and Low Volatility have also gained support from academic researchers and finance professionals.

However, if the assets under management in smart-beta ETFs are analysed it becomes apparent that allocations are spread among both the well-established factors and factors that are less, if at all, supported by empirical evidence.

The chart below shows the assets under management in smart-beta products as of early 2018, highlighting that inve