As we can see, ‘smart beta’ currently accounts for a sizable $75B in assets (or almost 9% of assets for US listed ETFs that provide domestic equity exposure). Given the interest in this space, we can expect this percentage to grow. At some point this has to hit a natural limit, since by definition, market participants in aggregate need to hold the market portfolio. However since ETFs as a category are still a minority of assets relative to mutual funds and individual security holdings, theoretically there is still adequate headroom for growth.
While ‘smart beta’ is a snappy marketing phrase, it could misleadingly imply that investing in these ETFs is ‘smarter’ than investing in traditional market cap weighted broad market ETFs. In reality, different risk factors will perform differently across market cycles. For example:
- Volatility vs. High Beta: The S&P High Beta Index has performed extremely well in the trailing 5 years (28% annualized total return through 3/17/14) vs. 19.5% for the S&P Low Volatility Index. This is to be expected since we are 5 years from the trough in March 2009, and the S&P 500 has had an annualized total return of 21.6% since that time. Going forward however, the current crisis in Ukraine, the slowdown in China and the relatively high equity valuations in the US could weigh on the market, and a rotation back into Low Volatility is likely.
- Equal Weighted vs. Market Cap Weighted: In the same trailing 5 years, the S&P equal weight index has significantly outperformed the S&P 500 (27% annualized TR vs. 21.6%). This is because equal weight ETFs are essentially providing a tilt towards relatively lower cap stocks, and mid-cap and small cap stocks have significantly outperformed large caps in this period. Once we move into a market environment where investors are more risk averse, we can expect this performance differential to reduce. In the case of equal weighting however (unlike with low volatility), its advocates will argue that its superior performance may persist relative to traditional cap weighting due to the ‘size premium’.
In conclusion, we estimate the size of the smart beta ETF space for domestic US equity exposure is already about $75B or 9% of the total ETF assets for domestic US equity. However ‘smart beta’ does not imply that these products will always outperform traditional market cap weighted products. Once we move into a more volatile environment, investors will rotate from high beta into low volatility ETFs and the performance differential between equal and cap weighted ETFs will reduce.
This article was written by Aniket Ullal, founder of First Bridge Data.
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