(Oct 9): Lately, a lot of media coverage has been given to the popular rise of smart beta exchange-traded funds (ETFs).
To recap, smart beta investing is about translating stock selection characteristics (such as earnings, cash flow, dividend yields and gearing) used by active managers into a fixed set of rules governing trades. This compares to simply following a traditional market capitalisation-based index.
The goal is to convert the alpha (of active management) into beta (still passive investing, cost-effective and transparent). This has become a strong marketing point for smart beta ETFs, attracting a tide of money from cost-conscious investors who are fed up with subpar returns by active fund managers.
Between 2008 and 2016, the assets under management (AUM) of smart beta ETFs has grown nearly 10 times from US$55 billion ($74.9 billion) to US$532.8 billion (see chart) according to ETF research firm ETFGI — a staggering compound annual growth rate of 32.8%.
Meanwhile, the number of smart beta ETFs has mushroomed just over four times from 297 to 1,213 in the same period.
In its 2016 annual report, BlackRock — the largest smart beta ETF provider by AUM — said assets managed under its smart beta strategies grew 37% for the year on the back of net inflows of US$20.2 billion.
While investors have ploughed money into smart beta ETFs, do they actually outperform passive ETFs, that is, the market?
To answer this, I compared the performance and cost of smart beta and passive ETFs that are based on three popular US indices: Standard & Poor’s 500, MSCI USA and Russell 1000 (see table).
It is still early days to tell whether smart beta ETFs will outperform.
But based on existing evidence, on average (over a three-year period in US dollar terms), smart beta ETFs have performed no better than their passive variants. This is based on the 9.50% average return for the 13 smart beta ETFs with a three-year track record versus 9.63% for the six passive ETFs sampled.
For now, it appears that smart beta ETFs are another suite of products offered by providers to justify charging higher fees, especially since price wars have driven plain-vanilla ETF fees to near-zero. Fees for S&P 500 smart beta ETFs range from 0.12% to 0.35% compared with 0.04% to 0.09% for the plain-vanilla versions.
Despite higher fees, it does not mean that all smart beta ETFs are not worth investing in. Case in point: iShares Edge MSCI USA Momentum Factor, which focuses on US stocks with high price momentum, has returned 14.2% a year over three years. This easily beats the passively managed db x-trackers MSCI USA Index UCITS’s 9.4% gains. The iShares S&P 500 Growth and iShares Russell 1000 Growth ETFs also beat their passively managed peers.
This leads me to believe that market timing also plays an important role in smart beta ETF selection. In an up market (which we are currently in), momentum and growth-focused investing typically performs better while value investing tends to shine over much longer investment periods.
To allow investors to capture returns in any market environment, ETF providers such as BlackRock and State Street Global Advisors have launched many types of smart beta products, some of which are fairly exotic.
For example, State Street’s SPDR S&P 500 Buyback (SPYB) provides exposure to 100 companies on the S&P 500 with the highest buyback ratio over the past year. Although SPYB’s AUM is small at just US$9 million, it goes to show the type of products providers can come up with.
We look forward to performing the above analysis on smart beta ETFs sold in Malaysia and Singapore. But the product offerings are currently quite limited relative to markets such as the US.
I realise that ETFs as a whole are usually sold on the basis of low costs. This is probably the single most important reason for its relative attractiveness over actively managed funds.
That said, fees are only one part of the equation when it comes to investing.
Ultimately, whether you are a stock, bond or ETF investor, relative performance and not low costs is the main consideration. Remember: Don’t be penny wise but pound foolish.
We will continue to monitor and write on smart beta ETFs in the future but my suspicion is that they are unlikely to perform any better than plain-vanilla ETFs. Why? As I explained in a past article, the residual return of an individual security from the market’s performance over time is either random or not — it cannot be both.
If it is random, then plain-vanilla ETFs generate the best returns for a given level of risk, according to the Modern Portfolio Theory. And our own test of robo-investing shows no clear indication it can outperform the market (see Issue 796).
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
