Economics & Finance
• 4 minute read

How Smart Beta Shakes Up the Investing World

A pioneer study by CUHK Business School shows the impact of smart beta ETFs on investors’ evaluation on mutual fund performance

By Jaymee Ng

It is no secret that exchange-traded funds (ETFs) have been attracting huge cash inflows from investors worldwide in recent years. With ETFs getting ‘smarter’, they are bound to shake up the world of investing.

Smart beta adopts an approach by tracking indices that weigh securities by factors other than traditional market capitalization. Smart beta ETFs take the advantages of both passive and active investing methods by constructing a portfolio that follows alternative index.

One of the most important considerations for investors is how to implement smart beta. A pioneer study published by The Chinese University of Hong Kong (CUHK) Business School may have the answer.

The study, led by Associate Professor Cao Jie in the Department of Finance at CUHK Business School, Jason C. Hsu, founder and CEO of Rayliant Global Advisors, Xiao Zhanbing, PhD student at the University of British Columbia and Zhan Xintong, Assistant Professor at Erasmus University Rotterdam, looks at how smart beta ETFs affect the asset management industry, in particular, the impact on how investors evaluate mutual fund performance.

The study is the first of its kind to investigate how smart beta ETFs affected active mutual funds with both US and cross-country evidence. Since April 2017, it has been presented at Cheung Kong Graduate School of Business, Peking University, Nanyang Technical University, and Singapore Management University.

Globally, the study has drawn great attention from asset management industry. It has won the 2018 ETF Research Academy Award by the Paris-Dauphine University House of Finance and Lyxor Asset Management (Paris), the 2017 CQA Academic Competition Award (Chicago), and the 2016 CQAsia Academic Competition Award (Hong Kong). It has been presented at the second Asian ETF Summit at Hong Kong with leading industry professionals. It has also drawn the attention of policy makers and been presented at China Institute of Finance and Capital Markets, the research center of China Securities Regulatory Commission.

The team tested the debate about whether smart beta ETFs could change fund flow sensitivity to alphas from different risk-factor models by analyzing nearly 4,000 unique US domestic equity mutual funds from 2000 to 2015. The researchers classified 747 ETFs into different categories based on two methods, and successfully identified 227 market-tracking ETFs and 520 non-market-tracking (smart beta) ETFs.

“We show that ETFs are more than simple indexing and tracking tools and can also provide exposure to multiple non-market risks,” says Prof. Cao, adding that significant increases of flow sensitivity to the Fama-French three-factor model, Carhart four-factor alpha, and seven-factor alpha were observed during a high non-market-tracking ETF trading period.

Theoretically, the performances of mutual fund managers are evaluated by their abilities of generating alphas. The study highlights that investors also reward fund managers for their exposure to non-market risk factors such as small minus big effect (SMB), high minus low (HML), and up minus down (UMD). However, what if smart beta ETFs can achieve the same risk-adjusted performance as actively managed funds but at a much lower cost?

“Our study suggests that the popularity of smart beta ETFs has elevated the bar with which investors evaluate the performance of active managers.” – Prof. Cao Jie

According to the study, investment in smart beta ETFs have increased significantly from US$160 billion to US$429 billion from 2008 to 2016. BlackRock, the world’s largest ETF provider, predicts that smart beta ETF assets will reach US$1 trillion globally by 2020.

Prof. Cao argues that investors reward mutual fund managers for non-market risk factors because they do not have sufficient investment tools to generate return associated with those risk factors by themselves. However, the emergence of smart beta ETFs has enabled investors to easily gain the exposure to various non-market risks and thus would prompt changes in investment behavior.

“With more investment vehicles available, investors can simply trade non-market-tracking (smart beta) ETFs to acquire returns related to SMB and HML, and therefore no longer reward the mutual fund managers for bearing such risk exposures,” says Prof. Cao. “In other words, the risk exposure of the mutual fund manager’s skills is easily replaceable.”

Investors are more cautious and skeptical in terms of evaluating portfolio manager performance. With more investment tools emerging, fund managers need to justify their premium fees by demonstrating their abilities of generating alphas that cannot be explained by easily measurable market factors such as size, value or momentum.

“Our study suggests that the popularity of smart beta ETFs has elevated the bar with which investors evaluate the performance of active managers. With intensified competition from such ETFs, mutual fund managers must provide superior performance after adjusting the influence of easily replicable risk factors,” says Prof. Cao.

Indeed, if fund managers fail to generate pure alphas, why not cut out the middleman? Yet, with so many low-cost, transparent ETFs flooding the market nowadays, it is getting increasingly difficult for fund managers to prove their skills.

“Active fund managers with the capability to provide pure alphas will receive more flow and continue to charge higher fees. Other fund managers may switch to managing smart beta products and charge lower fees,” says Prof. Cao.

Prof. Cao further warns that the hedge fund industry will face similar challenges in the future as the rapid development of new ETFs may replace those hedge funds that rely on the exposure to exotic risk factors.

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