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Have Strategic-Beta ETFs Delivered For Investors? (Part 1)

Assessing the track records of strategic-beta ETFs across the Morningstar Categories that make up the U.S. equity Morningstar Style Box

Ben Johnson 13/07/17

Strategic-beta exchange-traded funds track indexes that make rules-based, active bets in an attempt to deliver better returns, less risk, or some combina­tion of the two as measured against a conventional broadly diversified, market-cap-weighted index. As of the end of May, there were 637 strategic-beta exchange-traded products listed in the U.S. that collectively held US$619 billion of investors’ assets. Here, we will assess the track records of strategic-beta ETFs across the Morningstar Categories that make up the U.S. equity Morningstar Style Box.

Success Rates
The manner we’ve chosen to measure these funds’ success—or lack thereof—mimics the methodology of Morningstar’s Active/Passive Barometer. In each of the nine categories included in this analysis, we measure individual strategic-beta ETFs’ perfor­mance relative to an equal-weighted benchmark of their category peers that track more-traditional market-cap-weighted benchmarks.1 We believe this approach is more pragmatic than sizing these funds up against a single index as it: 1) incorporates the net-of-fees (and other costs) performance of investable alternatives and 2) avoids issues that might arise from cherry-picking a single index as a yard-stick (that is to say, results may vary widely depending on the index selected as a basis for comparison). Thus, our approach reflects the real-world perfor­mance of funds available to investors and accounts for the diversity of methodologies and resulting performance profiles across seemingly similar indexes.

We compared the performance of each strategic-beta ETF that existed at the beginning of the one-, three-, five-, and 10-year periods ended March 31, 2017, to the equal-weighted performance of their more-vanilla peers. For purposes of calculating success rates, a strategic-beta ETF is considered to have succeeded if it: 1) survived to the end of the period and 2) outperformed the equal-weighted composite of its cap-weighted counterparts. The results of this exercise appear in Exhibit 1.

Success rates across the nine categories we examined are mixed. Large-cap strategic-beta ETFs have gener­ally fared better relative to their mid- and small-cap peers. For the 10-year period ended March 31 2017, 84% of large-cap strategic-beta ETFs outperformed their average cap-weighted passive peer, while just 29% of their mid-cap and 33% of their small-cap coun­terparts managed the same feat. The most note-worthy results were produced by strategic-beta ETFs in the large-value category, where success rates were greater than 50% during the trailing three-, five-, and 10-year periods.

It is important to note that the sample of funds included in this analysis is small (see Exhibit 3), partic­ularly for the trailing five- and 10-year periods and outside of the large-value and large-blend categories. So, to complement the success rate data, we’ve also included the equal- and asset-weighted performance figures for both cohorts during the 10-year period ended March 31, 2017. Given the small sample sizes, average return data is a more reliable measure of these funds’ performance than the success rates, which may be skewed. Average return data is based on a composite of all funds that were available in a given month during the period in question. As such, it includes more funds over longer horizons and thus provides a more meaningful sample.

Exhibit 2 contains equal- and asset-weighted perfor­mance data for the 10-year period ended March 31, 2017, for both the strategic-beta and cap-weighted ETFs included in our analysis. Strategic-beta ETFs produced better equal-weighted returns relative to their cap-weighted peers in four of nine categories, including all three large-cap categories. Strategic-beta ETFs’ asset-weighted returns were higher in just two of nine categories. The triumph of the large-cap strategic-beta ETFs as measured by their success rates appears somewhat less glorious when viewing these same funds through the lens of their equal-weighted performance figures. In the case of the large-blend and large-growth categories, these funds’ margin of victory was somewhat narrow. On the other hand, the composite performance of the large-value strategic-beta ETFs trounced that of its cap-weighted cousins.

The performance data doesn’t reflect well on inves­tors’ fund-picking skill. In eight of nine categories, strategic-beta ETFs’ asset-weighted returns were less than their equal-weighted returns. This indicates that most of investors’ money has been plowed into funds that produced below-average results relative to the full menu of strategic-beta ETFs. Cap-weighted funds’ asset-weighted returns lagged their equal-weighted returns in five of nine categories. However, in the case of cap-weighted funds, the average difference between their equal- and asset-weighted returns was significantly narrower relative to strategic-beta funds. This speaks to the similarities in index construction among the cap-weighted cohort, which results in a relatively narrow distribution of long-term returns in this group.


1 We use ETFs that track market-cap-weighted value and growth indexes to form our benchmarks for the corresponding categories. These funds fit Morningstar’s definition of strategic-beta but have been carved out for purposes of this analysis.


In part 2 of this article, we will also look at the survivorship, risk-adjusted returns, factor exposure of these strategic beta ETFs.


About Author Ben Johnson

Ben Johnson  

Ben Johnson is the Director of Passive Fund Research with Morningstar.