Smart beta ETFs' risk adjusted performance against traditional market-cap weighted ETFs during volatile market

Abstract

During the last decade, smart beta ETFs have been increasing their popularity among investors. Smart beta ETFs fill in a field between passive ETFs and active funds by using fundamental factors in the portfolio construction process. Market capitalization weighted ETFs have already been gaining a large part of AuMs in the passive investment field, and now smart beta ETFs are taking part of the AuMs from active funds. Active fund managers are using fundamentals of the companies to choose which ones to include in the portfolios and smart beta ETFs are able to use fundamental factors similarly to active funds, but with lower fees. The factors are used with the aim to increase performance and/or to lower volatility. The purpose of this study is to find out if the smart beta strategies are able to compete and over perform market capitalization weighted ETFs using risk-adjusted performances as the measures. Market capitalization weighted ETFs are known to be very effective in risk-adjusted performances and active funds are not able to beat the markets on consistent basis. This is being analyzed by collecting data from 75 smart beta ETFs and comparing their historical Sharpe and Sortino Ratios against 5 market ETFs. Ten-year timeline is used which offers both up and downside volatility and stable growth periods, which gives both the aggressive and passive smart beta strategies an opportunity to benefit from their strategies. Proxy portfolios of Market, Minimum Volatility, High Dividend, Small Cap, Value, Momentum, Quality and Growth smart beta strategies are constructed by averaging the performances and volatilities of each smart beta ETF within each strategy. The analysis is being done using fixed effects panel data regression to see how each of the proxy portfolios compare against the Market. The findings of this study and the fixed effects regressions did not find any of the eight smart beta strategies to over perform the markets with risk-adjusted performances. The Market proxy seemed to have the most efficient balance between performance and risk, and when the smart beta strategies were trying to improve either performance or risk compared to the market, they were losing more on the other aspect. This does not mean that the market capitalization weighted portfolio is always the most efficient portfolio, and investors who wish to bear less or more risk than the market, can choose different smart beta ETFs to do this.