Smart Beta vs Factor Returns
Cousins, not Twins
August 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Smart beta ETFs are based on factor investing research
- Excess returns from smart beta ETFs are different from factor returns
- Investors need to be aware that smart beta ETFs offer little diversification for an equity-centric portfolio
INTRODUCTION
Blackrock, a provider of active and passive funds, estimates that smart beta ETFs will reach $1 trillion in assets by 2020 and $2.4 trillion by 2025. Smart beta is based on factor investing research, which categorises stocks into groups with similar attributes. Some factors, like Value, have been found to show structural positive excess returns across countries, sectors, and time. Although smart beta is based on factor investing and many investors take smart beta as proxies for factors, these are fundamentally different products. Factors are based on long-short portfolios while smart beta products are long-only with tilts toward a factor, which has a significant impact on the return profiles. In this short research note we will compare the returns of smart beta ETFs and factors.
METHODOLOGY
We’re going to focus on the largest smart beta ETFs in the US focused on Value and Growth. All of these have more than 10 years of trading history and at least $4bn in AUM. We calculate the excess returns for each smart beta ETF by deducting the benchmark returns from the smart beta returns. We also calculate the factor performance for Value and Growth by creating long-short portfolios comprised of the top and bottom 30% of the US stock universe. The portfolios are constructed dollar-neutral and include 10bps of transaction costs (read Factor Construction: Beta vs $-Neutrality). The table below provides an overview of the 14 smart beta ETFs used in the analysis.
