Smart beta ETFs more expensive than market-cap-weighted ETFs, finds Morningstar

Feb 23rd, 2016 | By | Category: Equities

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Smart beta exchange-traded funds are more expensive than their market-cap-weighted counterparts, according to a report from Morningstar.

Smart beta ETFs more expensive than market-cap-weighted ETFs, finds Morningstar

Smart beta ETFs are more expensive than market-cap-weighted ETFs, according to research from Morningstar.

Morningstar’s research report – “Assessing the True Cost of Strategic-Beta ETFs” – compared fees, replication costs and trading costs for 100 European-domiciled smart beta ETFs and 77 market-cap-weighted ETFs linked to broad equity benchmarks.

The research found that the average total expense ratio (TER) of a smart beta (or strategic) ETF using the S&P 500 as its parent index was three times higher than that of an ordinary S&P 500 ETF (0.43% compared to 0.14%). However, the average fee for an emerging markets smart beta ETF was only slightly more than that of its market-cap-weighted counterpart at 0.60% versus 0.53%.

The increase in costs was also put down to the relatively higher replication costs (smart beta indices experience turnover usually ranging from 20% to 30% per year whilst average turnover rates for standard market-cap-weighted indices are between 3% and 8%. There are also possible higher trading costs as a result of the smart beta ETFs being new, small and used as buy-and-hold investments, meaning they have low trading volume and therefore wider bid-ask spreads.

Hortense Bioy, CFA, Morningstar’s Director of European Passive Funds Research, said in a note: “Investors in strategic-beta ETFs, like those investing in actively managed funds, are more concerned with performance and the intricacies of a specific strategy than they are with cost… While this is understandable, they should keep in mind that there is a wide disparity in the fees charged by strategic beta funds, even by those offering exposure to similar strategies, and that low-cost funds have greater odds of future success.”

Smart beta ETFs have seen explosive growth in the last few years as investors have tried to improve performance or alter their level of risk in relation to a standard benchmark. Data from Morningstar shows that there were 950 smart beta exchange-traded products representing approximately $478 billion in assets worldwide, as of 31 December 2015.

Despite these higher costs it is still anticipated that investors will increasingly look to smart beta ETFs. In a study  by Invesco PowerShares last December, it was found that 60% of those surveyed felt smart beta would become a widely accepted investment strategy in the next few years. The survey looked at the drivers, challenges and implementation of smart beta as well as the potential for future adoption amongst users and non-users of the products in Switzerland, Italy, Germany and the UK.

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