Why factor and smart beta ETFs aren’t the key to better returns

A growing trend of factor investing in ETFs has seen the rise of smart beta or factor ETFs, but Stockspot founder and chief executive, Chris Brycki, has warned that these funds likely won’t deliver as expected and could cost investors more long-term.

Factor investing is a strategy that sees ETFs tilt their portfolios toward particular factors with the intent of capturing higher returns, promising investors a better version of index investing.

Common factors, according to Stockspot, include:

• Value (buying cheap shares).
• Size (buying smaller companies).
• Momentum (buying recent winners).
• Quality.
• Low volatility.

Some examples funds utilising factor investing include the VanEck MSCI International Quality ETF (QUAL) and Betashares Global Quality Leaders ETF (QLTY), both of which target companies with high profitability and stable earnings using different approaches, as the iShares Edge MSCI World Minimum Volatility ETF (WVOL), which seeks stable returns by owning lower-risk shares.

As this trend has gained traction, Brycki said it has driven the rise of smart beta or factor ETFs and managed funds that are designed to capture these return premiums “more efficiently than traditional market-cap indices”.

How this plays out in practice, however, is another issue entirely, with Brycki arguing there is little proof factors that performed well in the past will continue to do so.

“Once a factor becomes popular, studied, and sold through ETFs and other product structures, the advantage quickly disappears,” he said.

Notably, Brycki pointed to MSCI research earlier this year, which revealed that four in seven single-factor indexes underperformed the broader market by 2.6 per cent to 3.5 per cent annually.

While this doesn’t mean that targeting specific factors when investing never works, Brycki said they don’t work consistently, particularly once it becomes mainstream as the inflow of more investors triggers lower future returns.

“Chasing yesterday’s factors is no different from chasing last year’s top-performing fund manager. The promise of future outperformance usually disappears the moment everyone hears about it,” he said.

“While factors come and go, costs are forever. For investors, the smartest approach is to stay diversified, disciplined, and low cost. The only real free lunch in investing isn’t a factor. It’s diversification.”

Despite the concern, smart beta ETF flows doubled in July, sitting at $1.1 billion in flows, according to VanEck, up from $529 million in June as advisers increase their use of ETFs.

Speaking at the time, VanEck chief executive Arian Neiron said: “We are seeing greater interest in smart beta as investors increasingly seek broader investment opportunities that can offer diversification, selectivity, as well as targeted outcomes.  

“The macroeconomic and geopolitical landscape has seen considerable change this year, and smart beta ETFs provide investors with a convenient and cost-effective pathway to sophisticated investment strategies designed to perform through the cycle.”