Everyone’s got an opinion about smart beta.
For some, it’s the latest salvo in the passive revolution. For others, it’s a “marketing gimmick” that contradicts the basic premise of passive investing.
But for Jack Bogle, the founder of Vanguard, the problem with smart beta is more simple: they’re just “closet trackers”. Smart beta funds pretend to do something different and interesting – i.e., they pretend to be smart. But deep down inside, they’re hugging the index just like plain vanilla index funds.
“Given the remarkably high correlation of … smart beta ETFs with the return earned by the S&P 500, [they] could easily be classified as high-priced closet index funds,” Bogle wrote in his Little Book of Common Sense Investing.
Source: ETF.com; Portfolio Visualizer
So we decided to test Bogle’s theory. We went on ETF.com’s website and pulled the biggest 10 value ETFs by AUM. We then checked how closely they correlated with their plain vanilla market weighted counterparts using Portfolio Visualizer.
Our findings: Bogle was right, at least for the most popular value smart beta ETFs.
The biggest 10 US value ETFs all have a correlation with their market-weighted benchmark of 0.96 or higher. (Where 1.0 implies perfect correlation). In the case iShares MSCI EAFE Value ETF, the correlation was an incredible 0.99. Interestingly, Bogle’s remarks were also true of Vanguard’s own ETFs — which hugged the market-weighted index much the same as other companies’ value funds.
Value Tilted ETFs
Where things got interesting, however, was further down the AUM chain. The smaller and less popular value ETFs do not appear to hug the index. And indeed, by the time one gets to the very bottom of the AUM chain, the smart beta ETFs don’t correlate with the index at all.
Why might this be? I suspect it may have something to do with the fact that the largest ETF providers are making products for advisors who do not want to deviate too far from their benchmarks. But I’m just speculating.
Value factor funds