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Have Strategic-Beta ETFs Delivered For Investors? (Part 2)

Survivorship, risk-adjusted returns and factor exposure.

Ben Johnson 20/07/17

In part 1 of this article, we looked at the performance of the strategic beta funds. In this part will also look at the survivorship, risk-adjusted returns, factor exposure of these strategic beta ETFs.

Survivorship
The strategic-beta and cap-weighted funds included in this analysis are survivors. In both camps, survivor­ship rates were 80% or greater across all categories and time periods. The survivorship rates amongst strategic-beta ETFs are materially higher than those for traditional actively managed funds that we’ve documented in our Active/Passive Barometer. This difference is likely because this universe is much smaller, less saturated, and less mature than the market for active funds.

Risk-Adjusted Returns
What if strategic-beta ETFs outperform by simply taking on greater risk? To control for the level of risk these funds have assumed, we compared their Sharpe ratios (a measure of risk-adjusted perfor­mance) to those of their cap-weighted counterparts. Exhibit 4 shows average Sharpe ratios for each group across the nine categories for the one-, three-, five-, and 10-year periods ended March 31, 2017. By this measure, the gap between the two groups narrows significantly, indicating that the outperfor­mance of strategic-beta ETFs in some categories may be at least partially attributable to the fact that they have, on average, assumed more risk.

Factor Exposure
What about factor exposures? Most of these funds set out to harness well-documented factors like value, but are they doing so efficiently? To get a better understanding, we ran a three-factor regression of the monthly returns of our equal- and asset-weighted composites of strategic-beta ETFs in each of the nine categories to decompose the sources of their return into market beta, size (small minus big), and value (high minus low). We found that strategic-beta ETFs in seven of nine categories had greater exposure to the value factor than their cap-weighted rivals. Also, seven of nine categories had larger loadings on the size factor, indicating a skew toward smaller-cap names. Given that virtually all of these strategic-beta ETFs weight their holdings on the basis of some measure besides market cap, it’s no surprise that these funds tend to tilt towards cheaper and smaller stocks. 

Key Takeaways
1 | The 10-year success rates for strategic-beta ETFs in the large-cap categories were high but are some­what skewed, owing to the fact that the sample sizes were small.

2 | Strategic-beta ETFs’ results were mixed during the 10-year period ended March 31, 2017. Strategic-beta ETFs generated a higher equal-weighted average return than market-cap-weighted funds in four of the nine categories we analyzed. On an asset-weighted basis, they outperformed in only two categories.

3 | Investors have generally selected below-average performers from the menu of strategic-beta ETFs, as evidenced by the fact that strategic-beta ETFs’ asset-weighted performance exceeded their equal-weighted performance in just two of the nine categories we examined for the 10 years ended March 31, 2017.

4 | The survivorship rates were high across the board for both strategic-beta and market-cap-weighted ETFs. To date, strategic-beta ETFs survivorship rates have been much higher relative to actively managed funds.

5 | Lining up strategic-beta ETFs’ risk-adjusted returns against those for cap-weighted funds hints that some of these funds’ outperformance may be compensation for assuming greater risk.

6 | In every category but large- and mid-blend, strategic-beta ETFs had stronger exposure to the value factor. They also had slightly greater exposure to the small-cap premium (in all but the mid-blend and mid-value-categories).

 

Conclusion
Strategic-beta ETFs attempt to marry the best attri­butes of active and passive approaches to security selection. Their undeniable advantages over the majority of their actively managed peers include their relatively lower fees, greater tax efficiency, and the absence of idiosyncratic risk—namely key-person risk. Despite their advantages, on average, these funds aren’t a clear improvement over their cap-weighted counterparts. All we can say for certain is that they will deliver a risk/return profile that differs from the market. So, like their active peers, they will experience cycles of relative out- and underperformance. Ultimately, whether or not investors reap the benefits of investing in these strategies depends on their ability to stick with them through thick and thin.

About Author Ben Johnson

Ben Johnson  

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