Smart beta funds may not be the most cost-effective way to play factor investing, according to a new study that has attempted to mimic returns using a collection of market-cap weighted indices.
Research from Morningstar found that smart beta funds, marketed by asset managers as a more sophisticated way to invest, tended to be more expensive than traditional market-cap weighted passive products.
The report revealed that most smart beta offerings were not as distinctive as advertised, with returns easily matched by investing in a collection of cheaper products. The study was conducted by Alex Bryan, Morningstar’s North America director of passive strategies research, using a range of US-based US equity products.
Mr Bryan said: “Most of these [smart beta] funds just repackage market risk, along with size and value exposures that simple cap-weighted indexes can offer.
“Investors shouldn’t pay significantly higher fees for these strategies than market-cap-weighted alternatives, which capture the same performance drivers and can replicate most of their returns.”
Mr Bryan said most smart beta products attempted to outperform the market-cap weighted ones through screening or alternative weightings. But these attempts generally meant that funds were simply over or underweight smaller or cheaper stocks – something he said could be done manually, and more cheaply, via other passives.
To ensure products had 10-year track records, the study used a range of US smart beta funds launched prior to May 2007. Mr Bryan then created bespoke benchmark portfolios for each of the 65 funds using six different market-cap based indices.
The smart beta funds had total combined assets of $150bn (£116bn) with a median expense ratio of 0.39 per cent. The 65 funds on average charged more than four times the fee of the market-cap weighted indices being used for replication.
Mr Bryan said his analysis found that 92 per cent of the return variance of smart beta funds could be explained by exposure to the six underlying market-cap weighted indices. Only eight of the 65 funds had a fit of less than 85 per cent. Similarly, 58 per cent of the funds did not outperform their bespoke benchmarks over the 10-year period.
“The replicating portfolios fit the return patterns of the strategic-beta funds well,” he said.
“The fit was high for most of these funds because they did not distinguish themselves through security selection, portfolio rebalancing or timing the size or value factors. Also they did not generate differentiated performance from other factors such as momentum and profitability.
“Rather, traditional market risk, size and value/growth tilts could explain most of their performance,” Mr Bryan added.
A regression analysis to explain each smart beta fund’s underlying performance found that only one of the 65 funds generated either alpha or a return not explained by exposure to the six market-cap weighted indices.
However, Mr Bryan did caution on the complexity of using a collection of market-cap products to invest.“Even if their merits are sometimes exaggerated, many strategic-beta funds are still worth investing in. In many cases, it is more efficient to purchase a strategic beta fund than try to reassemble its factor exposures, which often shift over time.”
The study also looked at global equity and emerging market equity smart beta funds, and found that 89 per cent of returns in both sectors were driven by the six underlying market-cap weighted indices. But this part of the study used a smaller sample and was conducted over a five-year period.
Morningstar’s smart beta study
| Equity region | Time span (years) | Number of smart beta products | Averagecharge (%) | Average percentage of returns driven by market-cap factors |
| US | 10 | 65 | 0.39 | 92 |
| Global | 5 | 23 | 0.5 | 89 |
| Emerging markets | 5 | 15 | 0.63 | 89 |
| Source: Morningstar |
