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. The table below provides an overview of the 14 smart beta ETFs used in the analysis.

Smart Beta ETFs

Source: ETF.com, FactorResearch

VALUE VS GROWTH

Before we compare smart beta versus factor performance, it’s worth getting familiar with the Value and Growth return profiles. The chart below shows the excess returns of the two largest smart beta funds in the US, which are two products from Blackrock: IWD, which is focused on Value stocks, and IWF, which is focused on Growth stocks. We can observe that these two ETFs have a strong positive correlation (0.88) and look like inverse mirror images.

Excess Returns from Smart Beta ETFs Value (IWD) vs Growth (IWF)

Source: Blackrock, FactorResearch

VALUE: SMART BETA VS FACTOR EXCESS RETURNS

Value can be defined in various ways, but the common thread is picking stocks with cheap valuations. Given this, the return profiles tend to exhibit similar trends, despite different definitions for Value. The chart below shows the excess returns from the Value smart beta ETFs from 2000 to 2017. We can observe positive returns for all ETFs from 2000 to 2006, benefiting from the Tech bubble implosion. Heading into the Global Financial Crisis (GFC), returns turned negative. The return profiles are quite mixed thereafter, some smart beta ETFs generated attractive returns while others were flat or negative.

Excess Returns from Smart Beta Value ETFs

Source: Blackrock, Vanguard, FactorResearch

The next chart shows the excess returns of the Value smart beta ETFs compared to the Value factor performance. The factor is constructed by taking a long-short portfolio of stocks ranked by a combination of their book-value and price-earnings multiples, which is a fairly standard definition for the factor. We can observe that the factor generates much higher returns than any of the smart beta ETFs, which can be explained by the factor taking concentrated long and short positions while the smart beta funds have only overweights and underweights across all stocks in the universe. Investors who are familiar with Value factor returns and are using smart beta ETFs to harvest factor returns are likely to be disappointed by the excess returns from the ETFs.

Value Factor vs Smart Beta Excess Returns

Source: Blackrock, Vanguard, FactorResearch

GROWTH: SMART BETA VS FACTOR EXCESS RETURNS

The next chart shows the excess returns from the Growth smart beta ETFs. It’s worth highlighting that there is very little empirical evidence that there are structural positive returns in Growth over time, so it’s somewhat perplexing why investors have allocated billions to these ETFs. We can observe the mirror image of the Value smart beta ETFs in terms of excess return profiles. The Blackrock ETFs exhibit the same trends, which are quite different from the Vanguard ETFs (VUG & VBK), and likely reflect different stock universes and and definitions for Growth.

Excess Returns from Smart Beta Growth ETFs

Source: Blackrock, Vanguard, FactorResearch

The final chart compares the excess returns from the Growth smart beta ETFs to the Growth factor, which is based on a combination of sales-per-share and earnings-per-share growth. We can observe some similar trends, but the performance of the smart beta ETFs is lower than the factor performance over the period in nearly all cases.

Growth Factor vs Smart Beta Excess Returns

Source: Blackrock, Vanguard, FactorResearch

FURTHER THOUGHTS

This short note shows that excess returns from smart beta ETFs are quite different from the factor performance. Most investors will likely be familiar with the work of Fama-French and other researchers in the factor investing space, so should be aware that smart beta ETFs are based on factors, but do not provide the same return profiles.

Another, much more important point is that smart beta ETFs are long-only products, i.e. they offer very little diversification for an equity-centric portfolio. Investors should only consider smart beta ETFs as a replacement for existing equity funds or ETFs, otherwise they should look for long-short factor portfolios as only these offer true diversification benefits.

ABOUT THE AUTHOR

Nicolas Rabener is the Managing Director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, an award-winning quantitative investment manager focused on equity market neutral strategies. Before that Nicolas worked at GIC (Government of Singapore Investment Corporation) in London focused on real estate investments across the capital structure. He started his career working in investment banking at Citigroup in London and New York. Nicolas holds a Master of Finance from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

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