The Smart Beta Mirage

Abstract

We document and explain the sharp performance deterioration of smart beta indexes after the corresponding smart beta ETFs are launched for investment. While smart beta is purported to deliver excess returns through factor exposures, the market-adjusted return of smart beta indexes drops from about 3% “on paper” before ETF listings to about -0.50% to -1% after ETF listings. This performance decline cannot be explained by variation in factor premia, strategic timing, or diminishing returns to scale. Instead, we find strong evidence of data mining in the construction of smart beta indexes, which helps ETFs attract flows, as investors respond positively to backtests.

Keywords: ETFs, factor investing, smart beta, data mining

JEL Classification: G10, G20