Are widely accepted equity factor exposures available in fact to investors via “smart beta” mutual funds and exchange-traded funds (ETF)? In their May 2020 paper entitled “Smart Beta Made Smart”, Andreas Johansson, Riccardo Sabbatucci and Andrea Tamoni test effectiveness of individual U.S. equity mutual funds and ETFs and combinations of these funds for exploiting several major equity risk factors (value, size, profitability and momentum). After assembling a sample of funds with names that indicate smart beta strategies, they iteratively (annually for size, value and profitability and daily for momentum):
- Apply a double-regression to each fund to identify those that are actually “closet” market index funds.
- Refine factor exposures of each true smart beta fund based on actual fund holdings.
- Construct separately for institutional and retail investors tradable long-side (mutual funds and ETFs) and short-side (ETFs only) risk factors via value-weighted combinations of the 10 funds with the strongest exposures to each factor.
Using daily, monthly, and quarterly data for U.S. equity mutual funds and ETFs with (1) names indicating smart beta strategies, (2) at least one year of returns and (3)assets over $1 billion, data for their individual component U.S. stocks and specified factor returns during January 2003 through May 2019, they find that:
- About a third of mutual funds and ETFs with names that indicate smart beta strategies are instead closet market index funds.
- Both retail and institutional investors can track long and short legs of the selected factors fairly well, particularly when limiting selection of funds to ETFs. Funds available to institutional investors allow better factor return capture than those available to retail investors.
- However, neither set of investors can systematically capture conventional long-short factors via fund, except for:
- Value using both mutual funds and ETFs.
- Size when restricting choices to ETFs.
- Fund flows indicate that investors allocate to factors naively based on fund names rather than true factor replication.
In summary, evidence indicates that investors can capture significant portions of the long and short sides (but mostly not long-short combined) of some widely used risk factors via ETFs, but names of funds are not adequate for choosing funds.
Cautions regarding findings include:
- The methodology for identifying true smart beta funds is beyond the reach of most investors, who would bear fees for delegating the work to an advisor.
- Daily rebalancing to capture a momentum factor is impractical for most investors.
See also “ETFs for Harvesting Factor Premiums” and results of this search.
