Investing in smart beta ETFs
Smart Beta exchange-traded funds (ETFs) offer a way to get exposure to the investment tilts which many active managers use, to try and outperform a traditional market cap index. Almost without exception, these products offer back tested evidence showing that they can beat the market, but this is not consistent. Investors should take care to understand how they work.
Figure 1: Morningstar Style Box
Figure 2: Risk and return of MSCI Factor Indices
Figure 3: Factor exposures to the economic cycle
Are Smart Beta returns too good to be true?
In a paper titled “How can ‘Smart Beta’ go horribly wrong?", Research Affiliates analysed whether strong long-term performance comes from genuine alpha, or from a strategy becoming more and more expensive relative to the market. Their findings make for interesting reading.
They found evidence that Smart Beta factors can outperform in the long run, but even when you use a long return period (say 50 years), there is no guarantee that this outperformance isn’t simply driven mainly by rising valuations. For example, in the period between January 1967 and September 2015, Research Affiliates calculated that low volatility had more than half of its circa 1% excess return generated by changing valuations. Over 10 years it was even more pronounced; 1.65% of the 0.82% return was from changing valuations. In short, there was no alpha.
This illustrates that while factor exposures can make differences to your portfolio, they will not consistently outperform. In addition, chasing performances in Smart Beta ETFs that have done well can be just as injurious for your portfolio performance as buying stocks or individual markets which have recently performed well.
Smart Beta is a great tool for the investor’s armoury, but like all investments it pays to know a little about how it works before making a substantial investment.
Use our ETF screener to find the right global equity ETFs for you. ETFs can be bought on IG’s share dealing platform, where commissions start at just £5 and there are no custody or platform fees