Smart beta ETF issuers are relying on backtests and data mining to attract assets as “live” performance fails to deliver any sort of alpha.

According to new academic research, smart beta ETFs deliver above-average market returns of 2.77% a year prior to listing but once they go live this drops to a yearly underperformance of 0.44% despite claims these strategies can deliver alpha through a rules-based solution.

Although the first single-factor ETF was brought to market in 2003, it was not until after the Global Financial Crisis in 2008 when investors became disillusioned with active managers that the concept of smart beta took off.

Since then assets in smart beta ETFs have hit around $900m as investors piled into strategies supported by academically-backed research into factors such as value and low volatility.

The reason for this underperformance post listing, the report said, is due to “data overexploitation in backtests” which enables ETF issuers to attract flows from investors focused on past performance.

“Our results caution the risk of data mining in the proliferation of ETF offerings,” the authors stressed. “In fact, ETF issuers have strong incentives to present investors stellar backtested returns, as investors often pay attention to past performance, and stellar backtested performance could help ETF issuers attract investment flows.”

In particular, ETF issuers and index providers have a “degree of freedom” when it comes to index construction.

While smart beta ETFs are rules-based, the research said there is “substantial” discretion when setting the rules when the indices are being built.

As a result, index providers can leverage the large-scale data available to them and rapid growth in computing power to come up with some stellar index performance from thousands, “if not millions of backtests”, they argued.

This is part of the reason why two similar factor ETFs can deliver substantially different returns. An example of this is highlighted in our Q3 edition of Beyond Beta which pointed to the fact the S&P EM Small Cap index outperformed the MSCI EM Small Cap index by 5.4% in 2019.

With many smart beta ETFs launched in the last five to ten years, there is limited historical performance for investors to look at meaning they are more reliant on backtest data.

The huge drop in performance post-listing is extremely damaging to smart beta’s credibility at being able to deliver alpha.

ETF issuers need to take a look at their smart beta solutions and address any rule or index construction issues that are hindering performance or they will no longer have a market to sell to.