Active vs. Smart Beta ETFs: Two Sides of Active Management

Abstract

This article examines the characteristics and performance of active and smart beta equity exchange traded funds (ETFs) listed in the United States since 2000. Using a sample of 95 active equity ETFs and 376 smart beta equity ETFs, the author found that as of October 30, 2020, only 20% of active equity ETFs and 15% of smart beta equity ETFs performed better (in regard to return) than the S&P500 index (market) during the past five-year period. Using Fama–French–Carhart six-factor return attribution analysis, the author finds that more than 20% of smart beta equity ETFs and 10% of active equity ETFs have significant alpha at the 10% level of confidence after controlling for all Fama–French–Carhart factor returns. The excess market return factor is significant in all variants of return attribution analysis. All return attribution analyses reveal that the value investment category and the small-cap size category of both active and smart beta equity ETFs have 100% exposure to respective factor returns. There is significant scope for active and smart beta equity ETF fund managers to enhance the security selection process and create a better factor tilting strategy, respectively.

TOPICS: Exchange-traded funds and applications, factor-based models, statistical methods, performance measurement

Key Findings

• ▪ Twenty percent of smart beta equity exchange traded funds (ETFs) and ten percent of active equity ETFs have significant alpha at the 10% level of confidence after controlling for all Fama–French–Carhart factor returns. The excess market return factor is significant in all variants of return attribution analysis.

• ▪ Fund managers of smart beta equity ETFs need to create a better factor tilted strategy to gain maximum exposure to intended factors.

• ▪ Fund managers of active equity ETFs should focus on a better security selection process to maximize alpha, that is, minimize exposure to market and other known factor exposures.