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Investors Should Be ‘Skeptical’ of Smart Beta ETFs, Study Finds

New evidence shows that exchange-traded funds purported to capture factor premiums may not actually do so.

Investors looking for exposure to investment factors like value or momentum may be better off avoiding exchange-traded funds, according to a working paper from France’s IÉSEG School of Management.

In June 2017, there were 1,320 smart beta ETFs with more than $700 billion of assets under management, according to Morningstar data cited in the paper. These products “aim to provide factor exposure in a cheap and transparent way,” wrote Alexandre Rubesam, an assistant professor of finance at IÉSEG, and co-author Soosung Hwang, a financial economics professor at Sungkyunkwan University in South Korea.

When the duo analyzed the performance of smart beta ETFs, however, the result raised questions about the products’ ability to deliver excess returns from factors including value, momentum, profitability, and investment.

“Investors should be skeptical about the ability of smart beta ETFs to capture factor premiums,” Rubesam and Hwang warned.

[II Deep Dive: The ‘Vanguard Effect’ Comes to Smart Beta]

For the study, the researchers analyzed 368 active U.S. equity ETFs with return data over the five years through 2017, including 200 smart beta funds. By comparing the performance of the smart beta ETFs to both a benchmark nine-factor model and generic ETFs, they determined that the returns of smart beta ETFs were best explained by a tilt toward small-cap stocks, or the size factor.

To a lesser extent, smart beta ETFs also had exposure to the low-volatility and betting-against-beta factors, which entail buying low-beta stocks and selling or shorting high-beta, or high-volatility, assets. 

In addition, the researchers found that smart beta ETFs were actually more correlated to the broader market compared to non-factor-related ETFs – despite the fact that many smart beta ETFs “explicitly attempt to capture premiums” from factors including value, momentum, and volatility.

“It is unlikely that these smart beta ETFs are exploiting other factors,” Rubesam and Hwang concluded. “This result severely questions the ability of smart beta ETFs to capture factor premiums.”

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