The ‘Paradox’ of Smart Beta

Smart beta exchange-traded funds have become popular among investors disappointed by the performance of higher cost, actively managed mutual funds, according to researchers from the ESSEC Business School. But they are the best choice among ETFs?

“Smart beta funds do not offer a risk-adjusted performance superior to active and passive strategies,” ESSEC finance professors François Longin and Makram Belallah and business school student Youssef Louraui said in a paper this month. Still, smart beta ETFs, which invest using a hybrid of active and passive strategies, have seen strong growth in assets, which the authors pegged at about $560 billion last year.

For their study, they analyzed 51 ETFs over a roughly one-year period through April, including 18 tied to smart beta, 14 actively managed funds, and 19 that passively track indexes. The authors used data from ETF.com to evaluate the performance and persistence of smart beta strategies, noting the Covid-19 pandemic may have affected their findings.

“Smart beta aims to deliver higher returns with fewer management fees,” the researchers said, calling the growth of the market a “paradox” considering the disappointing results of such ETFs.

“It is undeniable that smart beta strategies are of considerable importance in the ETF market, and that their growth in recent years has been impressive,” the authors said. They also pointed to BlackRock’s prediction in 2016 that smart beta ETF assets could swell to $2.4 trillion by 2025.

ETFs have boomed since they were first introduced in 1993, with the industry now overseeing more than $4 trillion assets, according to the paper. The authors said the smart beta market has grown at an annual rate of about 17 percent from 2010 to 2019, exceeding actively managed ETF assets by almost fivefold.

The ESSEC researchers aren’t alone in raising concerns about smart beta performance.

[II Deep Dive: Smart Beta Managers Are Boasting ‘Utterly Implausible’ Returns, Research Affiliates Says]

A year ago, Research Affiliates warned in a paper that some smart beta managers were advertising historical returns “too good to be true,” using backtests to claim their unrealistic results. At least one rival factor strategy provider had claimed annualized excess returns as high as 4 percent over the past decade, and without underperforming during any calendar year versus the cap-weighted index, Research Affiliates said at the time.

“Smart beta is still a fast-growing industry, probably due to the theoretical advantages it promises to counter the inefficiency of cap-weighted indices,” the ESSEC authors said.