The difference of theory and praxis: the problem with smart Beta ETFs!

Beating the market consistently is a challenging task. There are plenty of academic papers that claim they solved this issue and when you study the academic work, you’ll find plenty of strategies that outperform the market over time.

Smart exchange-traded fund (ETF) providers translated these strategies into funds. These smart beta ETFs use momentum approaches or “Dividend Aristocrats” to beat the market. Each of these strategies is backed by research, mostly conducted by the world’s leading business schools and investment banks.

But the real-world performance of smart beta ETFs is actually disappointing. It seems that once a strategy is introduced through an ETF, it stops working. But why is this so?

Campbell Harvey, a professor of finance at Duke University estimates that at least 50% of the 400 “market-beating” strategies identified in top financial journals over the past years are worthless. He challenges academics to take any so-called winning strategy and ask a different set of researchers to replicate it. The chances are about 50-50 that they can’t. And this phenomenon is called the replication problem.

The problem is, researchers twist the data blatantly or subconsciously. They may cherry-pick the metrics used or adjust the time period studied to obtain a statistically significant result. As a result, investment strategies that look terrific on paper often flop in the real world.

I was curious, if these market-beating strategies offered by smart beta ETFs would work but have been disappointed by their real-life performance.

Sven Franssen