Smarter Beta? Part 1 of a Series on Multifactor Smart Beta ETFs

Is it alpha or is it beta? Is it smart beta, or is it dumb? Can it be timed, or is that dumb? Is a crash looming? The questions fueling “smart beta” debates carry on, but that hasn’t stopped a number of providers from launching a “smarter” product – and from picking up assets as a result. In this first post of a series, MPI will begin to explore multi-factor smart beta, an up-and-coming take on the strategic beta concept.

In a rare case of general consensus, a major complaint about smart beta products is that while the factor(s) emphasized may exploit anomalies that will continue to be rewarded in the long run, it is by no means the case in the short to mid-term. Any given smart beta strategy will have different associated risks than a cap-weighted index, as well as potentially long periods of underperformance.  Examples include periodic crashes in momentum strategies; value underperforming growth for most of the past decade; small cap stocks generally being more volatile than large cap and tending towards deeper drawdowns; rate sensitivity in low-volatility strategies; and so on.

Enter multi-factor smart beta.  By combining several factors, all of which will (again, presumably) do well in the long term, the shorter-term underperformance of any one or two individual factors can be compensated for by the returns of their better-behaved companions. The usual pitch is that the funds maintain the goal of outperforming the market while offering diversification in terms of both factors and holdings concentration (reducing the dominance of a few mega-cap names).

A number of multi-factor smart beta ETFs are celebrating their one-year anniversaries. Multi-factor smart beta products already span a number of segments, including global stocks, small, mid and large cap stocks, as well as specific sectors and other asset classes.  A comparison encompassing all of these wouldn’t provide a lot of insight, so we created a narrower, more similar group, setting the following criteria¹:

• The ETF possesses intentional exposure to a minimum of three of the five most common targeted factors: Value, Quality, Momentum, Size² and Low Volatility
• The ETF is managed to a rules-based index
• The parent universe is US large or total market cap (ie S&P 500, Russell 1000 or Russell 3000)
• The ETF is categorized as Large-cap in the Morningstar US database

The 12 funds produced are shown in the table below along with fundamental data provided in Morningstar US databases.

Although it is by necessity a very, very short period of time – the common period for all funds only dates back to December 3^rd, 2015 – the group of funds show a surprising range of results.  The performance figures are shown with return performance for the 6 month period ending June 2^nd, 2016 against a backdrop of large cap core actively managed mutual funds³.

The color groupings represent funds which target the same specific group (1-7) of targeted  factors. Not only is there a broad range in performance in the total group of funds (ranging above and below the 95^th and 5^th percentile of the active peer group), those with the same nominal exposures do not necessarily appear similar to each other. The visible spread in performance for funds with the same targeted factors indicates that the group dispersion is not wholly a product of the choice of which factors to pursue but also stems from how they are implemented.

Observations

• The clearest takeaway from our first look is that the group we selected isn’t particularly homogenous.
• The manner in which specific factor exposures are implemented (even the same stated target ones) may differ from fund to fund. This can obscure expectations for the behavior of these products.
• Factor exposures targeted do vary considerably, with at most 3 ETFs targeting the exact same set. The only factor targeted by all funds is Value, followed in frequency by Momentum and Quality and finally Size and Low Volatility.
• Four funds appear to be more concentrated than the iShares Russell 1000 Index ETF included in the table for comparison purposes, as measured by % of assets in top 10 holdings.
• Four funds appear to have more of a growth tilt than the expected value tilt, using average Price/Book ratio compared to that of the iShares Russell 1000 Index ETF.
• All but two funds report comparable or higher ROE values vs the iShares Russell 1000 Index ETF. ROE as a profitability measure is often used in determining quality factors, and it is worth noting that the two that do not report higher values are the only two which do not target quality as a factor exposure.
• While only six of the twelve funds target size as a factor, all but three report a significantly smaller average market cap than the iShares Russell 1000 Index ETF, indicating that smaller size may be acquired as an exposure even when not specifically targeted.

Investors should have a clear understanding of the exposures and risks inherent in their portfolios. The premise of these funds is an attractive one at first glance, supported by the assets continuing to pour into smart beta products.  However, a closer look at this group raises more questions than answers, and hints at the potential complexity of the product range. The characteristics of these funds are not as transparent as they could be to either investors or analysts, and are a prime candidate for more in depth analysis, particularly in terms of targeted factors.  In our next post, we will delve into the effective exposures of some of these funds under the objective lens of returns-based style analysis.

Footnotes

• 1Please note that our search process did not necessarily capture all funds meeting our criteria; it is possible additional funds exist in this space.
• 2Size in this case tends not to refer literally to small cap stocks, but smaller capitalization within the parent universe.  These tend to present as mid-cap rather than small-cap.
• 3Defined by the Morningstar Large Cap Core category