What’s hot and what’s not among ETFs that aim to beat the market

A Morningstar analyst runs the rule over the smart beta ETFs, which aim to deliver a middle ground between active and passive funds.

Strategic beta, widely referred to as “smart beta”, refers broadly to a group of indices and the exchange-traded funds (ETFs) that track them.

Most seek to enhance returns or minimise risk relative to more traditional benchmarks. Others seek to address oft-cited drawbacks of standard benchmarks, such as the negative effect of contango in long-only commodity futures indexes, and the overweighting of the most indebted issuers in market-value-weighted fixed-income benchmarks.

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These indices may also aim to capture a specific factor or set of factors such as value, momentum, small size, low volatility or quality.

Strategic-beta funds account for a modest share of approximately 6.8% of the total pool of ETF assets domiciled in Europe. Since 2015, this market share has fluctuated between 6% to 8%, indicating that the European market for strategic beta funds has reached maturity. Moreover, asset managers have shifted their focus to other emerging areas, such as sustainable and thematic products.

The strategic beta ETF industry initially saw a period of growth, the number of launches peaked in 2017 when 80 new products saw the light of day. However, the number of launches has since been on the decline.

The most-popular launch in this space outperformed in 2022

Only four new strategic-beta ETFs were launched in Europe in 2022. Among these, the iShares S&P 500 Equal Weight ETF USD Acc GBP (LSE:EWSP) stood out, successfully accumulating $717 million.

The fund's launch was impeccably timed. Last year, the S&P 500 Equal Weighted Index outperformed the S&P 500 for the first time since 2016. This was driven by the technology giants having a notable pullback in 2022, following almost a decade of impressive gains.

This shift in performance can be illustrated by contrasting the S&P 500 - where technology and communication services once held a combined weight of nearly 40% at their peak - with an equal-weighted index that doesn't assign such large allocations to the two sectors.

The other three ETF launches have failed to gather more than $20 million in assets, each.

Investors embracing dividend funds amid bond market uncertainty

ETFs belonging to the dividend strategic-beta group continue to dominate the strategic-beta ETF market. In 2022, the highest flows of more than $6.7 billion went into dividend strategies. As 2022 marked a period of historic downturns in the global market, many investors found themselves reconsidering their strategies for income stability.

Moreover, the traditional negative correlation between equities and bonds, often relied on for diversification, seemed to wane in 2022. Against that backdrop, dividend funds offered an attractive alternative for those seeking regular income and some measure of stability. So far in 2023, dividend funds are also receiving the highest inflows.

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In 2022, investors grappled with economic turbulence, including rising inflation, fluctuating markets, losses in tech, amid ongoing pandemic challenges. In this uncertain climate, strategies that aim to keep a lid on risk came back into favour. These minimum-variance or low-volatility ETF strategies seek to offer investors a balance between gaining equity market exposure and minimising risk.

Fast-forward to 2023 and low-volatility strategies have found themselves out of favour due to their lighter exposure to technology and above-market exposure to financial services. Year-to-date, risk-oriented strategies have experienced the highest net outflows.

iShares remains market leader

ETF behemoth iShares comfortably retains the number one spot in the European strategic-beta ETF space with a market share of over 45%. Its Edge branded suite of ETFs that track factor indices focused on global, US, and European exposures has played a key role in cementing the firm's standing in recent years.

Xtrackers sit in a distant second place with a market share of 9.0%, largely built on the popularity of the Xtrackers S&P 500 Equal Weight ETF 1C GBP (LSE:XDWE). By equally weighting the constituents of the S&P 500, the fund offers exposure to the size factor in US large-cap equities. The popularity of this strategy can be explained by the fact that smaller companies have historically outperformed their larger counterparts in economic recoveries.

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Third in the provider table is SPDR, State Street's ETF franchise. SPDR's growth has been largely led by its flagship Dividend Aristocrats products. However, the firm also offers exposure to risk-oriented and value strategies. In June 2021, State Street launched ESG alternatives to its European, US, and Global Dividend Aristocrats strategies. However, assets in these products have stayed low, perhaps signalling the market's lack of demand - at least at this stage - for strategies that pair ESG with factor investing.

Strategic beta comes with a premium price  

Europe-domiciled strategic-beta ETFs still demand a sizeable fee premium above their market-cap weighted equity peers. On the equities side, single-factor ETFs generally remain fairly priced, with most of their fees coming in under 0.35%. Where fees start to tick up is on less-popular strategies in the fundamentals and growth strategic-beta groups, or more complex multi-factor ETFs.

In most asset classes, strategic-beta ETFs tend to command a higher fee than their mainstream counterparts.

This disparity is most evident in the realm of commodity strategic-beta products, where the average fee is 0.84%, compared with the more modest 0.66% for mainstream offerings.

However, when assessing these fees based on asset-weighted terms, the difference is less significant, standing at 0.33% for strategic-beta ETFs versus 0.23% for mainstream products.

Monika Calayis director of passive strategies research, Europe, for Morningstar UK.