Smart Beta ETFs Not So Smart?

Smart beta ETFs that were on fire for quite some time now appear to be losing some momentum. Smart beta strategy helps to exploit market anomalies by adding extra selection criteria to the market cap or rules-based indices. These include among other strategies value – stocks trading cheap but performing better than stocks trading at a higher value, momentum – based on ongoing trend, dividend – stocks paying high dividend perform better in the long run and volatility – stable stocks perform better any day.

In fact, the popularity of smart beta has soared to such a point, where a Create-Research survey has found that smart beta ETFs make up for around 18% of the U.S. ETF market. The U.S. markets are experiencing extreme volatility and the factors responsible for it are global growth concerns, escalating geo-political tensions, a surge in the U.S. dollar and uncertainty over the timing of the next interest rate hike. Against this backdrop, investors look for smart stock-selection strategies to alleviate market risks.
 
But nothing works forever, not even smart strategies. This is as true for smart beta ETFs as for market anomalies. Per a report by Research Affiliates’ analysts, one of the primary reasons why smart beta strategies have been performing well is because of their growing popularity, which led to higher valuations rather than structural alpha. The latter is the quality of the strategy and its potential to beat the benchmark on a sustainable and repeatable basis.
 
This does not mean that one should reject smart beta ETFs altogether. If any inefficiency is spotted in the market, smart beta ETFs enable investors to exploit it at a cheap cost. However, it should be noted that not all smart beta ETFs have fulfilled their promise of delivering market-beating returns.
 
Below we have highlighted a few ‘Smart Beta’ options that underperformed the broader U.S. market ETF SPDR S&P 500 ETF (SPY), which has gained about 1.6% so far this year (as of March 30, 2016)
 
First Trust Dorsey Wright Focus 5 ETF (FV)
 
This ETF tracks the Dorsey Wright Focus Five Index, which provides targeted exposure to the five First Trust sector and industry-based ETFs that Dorsey, Wright & Associates (DWA) believes have the highest potential to outperform other ETFs in the selection universe. It is a popular ETF with AUM of $4.6 billion and trades in solid volumes of around 2.2 million shares a day on average. The fund charges a higher 89 bps in fees. The ETF has lost 8.2% in the year-to-date period (as of March 30).
 
Guggenheim S&P SmallCap 600 Pure Growth ETF (RZG)
 
This fund tracks the S&P SmallCap 600 Pure Growth Index. The product has a wide exposure across 146 stocks with each holding less than 2% share while health care and financials are the top two sectors accounting for over 20% share each. The ETF has AUM of $192 million but trades in light volume of about 28,000 shares a day on average. It charges 35 bps in annual fees and fell 2.4% in the year-to-date period.
 
SPDR Russell 1000 Momentum Focus ETF (ONEO)

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