What is driving the rapid slowdown in smart beta ETF launches?

A sign of market saturation or something more structurally significant at play? Tom Eckett, deputy editor at ETF Stream, investigates the dramatic decline of smart beta ETF launches over the past two years

Once described as the “most significant trend in ETFs” in 2016, smart beta ETF launches have fallen off a cliff in the last two years as issuers appear to have moved on to developing other investment strategies such as ESG and thematics.

Towers Watson first coined the term smart beta in the early 2000s but it was not until 2003 the first single-factor ETF was launched, when Rydex brought to market an equal-weighted version of the S&P 500 (RSP) in April that year.

However, it was not only after the Global Financial Crisis in 2008 when investors became disillusioned with active fund managers that smart beta as a concept began to take off.

With its origins tracing back to the academia of Benjamin Graham and Fama-French, smart beta strategies offered investors the perfect promise of outperforming the market while employing a rules-based approach. Recognising the opportunity, ETF issuers began to launch smart beta products at a rapid pace in order to capture the rapidly growing demand. This culminated in the three years between 2015 and 2017 when 203 smart beta ETFs were brought to market.

Investor demand followed with smart beta assets under management (AUM) reaching $616bn in 2016 and now total approximately $818bn, according to data from FactSet. However, new launches have almost ground over the past two years. According to data from Bloomberg, there have been just 9 smart beta ETFs launches in 2020, as of 25 August, and there were 11 last year compared to the 203 launches between 2015 and 2017.

What has happened in the past two years to cause such a dramatic decline in new products? Is it simply a case of the market maturing to the point where no further launches are needed or is there something more structurally significant at play?

One obvious reason for the drop in launches is ETF issuers are turning their attention to other parts of the market where they see rapidly growing investor demand. One of these segments is ESG investing which has seen rapid growth over the past two years.

According to data from Morningstar, there have been 46 ESG ETF launches in Europe this year as of 30 June, 11 more than the previous highest in 2018. A recent report by Citi analysts predicted ESG and thematics will replace smart beta which can sit as both satellite and core holdings. The report also called for the breakdown of smart beta as an overarching definition into three distinct categories; single factor ETFs, dividend ETFs and multi-factor ETFs.

“Smart beta has become passé,” the analysts said. “The immediate challenge to broader smart beta growth is the emergence, and adoption, of both ESG and thematic solutions. ESG has been more effective in displacing traditional core indices, while thematic differentiation is increasingly more attractive for longer-term alpha seekers.”

Market saturation

However, the slowdown in launches is arguably part of the natural progression of a maturing market. If there are only five or six academically-backed factors, this limits the number of smart beta ETFs that can be launched.

As Athanasios Psarofagis, ETF analyst at Bloomberg Intelligence, said, the universe has been well filled out following the rush of launches in 2016 and 2017. “In 2016, there was a massive push in low volatility strategies but this has shifted to ESG and thematics this year.

“This is pretty normal,” he continued. “Issuers always change focus so what used to be smart beta is now ESG and thematics.”

Steven Goldin, managing partner and CIO at Parala Capital agreed. He said the slowdown was just a case of “digestion”. He said different factor strategies can have different returns despite both being called ‘small cap’, for example, so it was a case of the market “vetting” which strategies have done what they were supposed to do.

In a previous article for Beyond Beta, he highlighted how the S&P EM Small Cap index outperformed the MSCI EM Small Cap index by 5.4% in 2019 due to the macroeconomic factors at play.

“Many issuers saw smart beta as an opportunity due to the low barriers to create these strategies, however, it is an overproliferated market so it is just a case of vetting each strategy and see how they perform,” Goldin said.

Poor performance

However, the reason for the slowdown in smart beta launches could be driven by something more structurally significant. Recent academic research, entitled The Smart Beta Mirage, has found smart beta ETFs suffered from a “sharp” drop in performance after they were listed.

According to the co-authors Yang Song at the Univseristy of Washington and Shyang Huang and Hong Xiang at the University of Hong Kong, the average return of smart beta indices drops from 2.77% per year before ETF listing to -0.44% per year after listing.

They concluded: “We find evidence of data mining in constructing smart beta indexes as the post-ETF-listing performance decline is much sharper for indexes that are more susceptible to data mining in backtests. Our results caution the risk of data mining in the proliferation of ETF offerings as investors respond strongly to the stellar performance in backtests.”

Data mining has been a big issue for the smart beta industry. Even many academically-backed factors have underperformed once gone “live” leading to many to describe the proliferation of factors as the ‘factor zoo’.

This significant underperformance could be driving ETF issuers away from smart beta into the arms of ESG, an area of the market that has been outperforming over the past decade. It will only be in the next few years when there is sufficient past performance that the market will be able to determine which smart beta ETFs are viable products and which need to be left on the shelf.

This article first appeared in the Q3 2020 edition of Beyond Beta, the world’s only smart beta publication. To receive a full copy, click here.

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