Korea Capital Market Institute

Global asset management companies have competitively launching ETFs as ETFs boasting their low-cost and efficient index-tracking features have garnered increased attention as long-term investment vehicles. Especially, smart beta ETF products rose to mainstream in recent years. In 2015, a total of 34 asset management companies in the U.S. released 156 smart beta ETFs, representing 57.1% of all new ETF products launched in the U.S. during the period. The market for smart beta ETFs in the U.S. has grown rapidly. After exceeding $100 billion for the first time in 2010, it reached $200 billion in 2013 and $450 billion in 2015, and most of the increase in market size was driven by large cash inflows.

Smart beta ETFs are gaining popularity because they complement the shortcomings of existing actively and passively managed funds, where active fund managers have limited ability to pick enough winners to justify their high fees and market cap-weighted passive funds provide only narrow investment opportunities. Smart beta ETFs’ merit lies in its mix of product diversity with passive funds’ low cost structure.

This paper investigates the characteristics of smart beta ETFs by examining the performance of U.S. and Korean smart beta ETFs. It compares the market cap-weighted benchmark with simple performance indicators such as the monthly average return, standard deviation, and Sharp ratio of representative products, and measures the efficiency of smart beta ETFs using the regression analysis. Also explored are their sensitivity to alternative factors such as SMB, HML, and UMD, and their performance during sudden market swings.

The results show that the overall sensitivity of the U.S. smart beta ETFs to their benchmarks remains high. This could be attributed to ETFs’ structural limitation that could not construct a long-short portfolio, but it does not necessarily mean that they depend solely on market cap weighting. Smart beta ETFs’ performance is largely linked to the changes in alternative factors, via which some of the funds are efficiently reaping profits. Dividend, quality and low-vol strategies outperform their benchmarks, whereas value, momentum and equal-weight strategies are found to underperform in the U.S. market. This clearly shows that although a smart beta ETF adopts a strategy whose historical performance has proven to be good in the academia and the industry, this does not guarantee investors superb future results in the real world. 

Also found is that smart beta strategies overall have shown good historical performance in the Korean stock market. As is the case for the U.S. market, a significant portion of their return premiums stems from alternative factors rather than market risk. However, their performance is significantly weak during the latter half of the analysis period.

Going forward, the market for smart beta ETFs will continue to grow both domestically and internationally. The growth will not be limited in the market size, but also will involve a qualitative evolution with product diversification and fierce competition. In line with the growth of the smart beta ETF market, investors will be able to tap into a variety of alternative factors for easily diversifying their investments, and construct a more sophisticated portfolio to suit their own risk preferences. However, it is important for both managers and investors to bear in mind that smart beta ETFs do not always beat the market with “smart” performance as the name suggests.