Strategic beta ETFs (also widely known as smart beta ETFs) may not be as distinctive as advertised – market capitalisation weighted ETFs may be able to capture some of the performance drivers of strategic beta alternatives at a lower cost. These are the findings from Morningstar, released in conjunction with its annual report on the global strategic beta ETF landscape.
The Morningstar research argues that investors should not be prepared to pay significantly higher fees for strategic beta ETFs.
Alex Bryan, director of passive strategies research, Morningstar, commented: “Strategic beta funds aren’t as distinctive as they may first appear. It’s possible to replicate most of their performance with size and value exposures that simple market cap-weighted indices can offer, suggesting that most of these funds just repackage market risk.”
The Morningstar research attempted to replicate strategic beta fund performance using combinations of market cap-weighted alternatives. The results show that investors could indeed replicate most strategic beta funds’ performance with various different value, growth and size segments of the market.
Such an approach isn’t necessarily advisable because it is impossible to know the exact composition of the replicating portfolio ahead of time and it is easier to buy one fund instead of several. However, the results do suggest that the value of strategic beta funds comes from how they repackage traditional style exposures, rather than fundamental differences such as superior selection, outperformance from timely portfolio rebalancing, or harnessing distinctive factors.
The report claims that the fees of some strategic beta ETFs can be several times higher than the cost of replicating their performance using market cap weighted-substitutes. Bryan added: “Investors shouldn’t pay significantly higher fees for these strategies than market cap-weighted alternatives, which capture the same performance drivers and can replicate most of their returns.”
However, Bryan does go on to point out that even if their merits are sometimes exaggerated, strategic beta funds are still worth investing in because in many cases it is more efficient to purchase a strategic fund than trying to assemble its underlying factor exposures, which often shift over time.
In the accompanying strategic beta ETF landscape report, Morningstar finds that as of 30 June 2017, there were 1,320 strategic beta ETFs, with collective assets under management of approximately $707 billion worldwide, up 28% from a year earlier.
In recent years, the assets and number of funds in the strategic beta segment have grown more rapidly than the broader ETF market, as well as the asset management industry as a whole. Recent growth has been driven by new cash flows, new launches and the entrance of new players, some of which are traditional active managers.
Morningstar expects these trends to continue and may ultimately accelerate as newer ETFs tracking new and unproven benchmarks season and more new entrants make their way into the market.
There were 204 new strategic beta ETFs brought to market in the 12 months through June 2017, down slightly from 211 during the prior period. More strategic beta ETFs were introduced in Europe than all other regions combined.
A commonality among the markets examined by Morningstar is the increasing complexity of the benchmarks underlying new strategic beta ETFs. Providers are increasingly looking to multi-factor and factor-timing ETFs for new product launches.