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The Smart Beta Mirage

Published online by Cambridge University Press:  11 May 2023

Shiyang Huang ,
Yang Song  and
Hong Xiang
Shiyang Huang
Affiliation:
The University of Hong Kong HKU Business School huangsy@hku.hk
Yang Song
Affiliation:
University of Washington Foster School of Business songy18@uw.edu
Hong Xiang*
Affiliation:
The Hong Kong Polytechnic University Faculty of Business School of Accounting and Finance
*
hong.xiang@polyu.edu.hk (corresponding author)
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Abstract

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We document and explain the sharp performance deterioration of smart beta indexes after the corresponding exchange-traded funds (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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 6 , September 2024 , pp. 2515 - 2546
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (https://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Itzhak Ben-David, Hendrik Bessembinder, Philip Bond, Jennifer Conrad, Darrell Duffie, Ralph Koijen, Charles M. C. Lee, Jiacui Li, Jeff Pontiff, Riccardo Sabbatucci, Stephan Siegel, Yuehua Tang, Yao Zeng, Zhuo Zhong, several BlackRock and Vanguard professionals, and seminar/conference participants at the University of Amsterdam, Erasmus University Rotterdam, the University of Warwick, the University of Washington, the University of Hong Kong, Victoria University of Wellington, Renmin University of China, the Joint Seminar by the University of Melbourne and the Financial Research Network (FIRN), the University of International Business and Economics, the 2021 Eastern Finance Association Annual Meeting, the 2020 Australasian Finance & Banking Conference, and the Virtual Asset Management Seminar for helpful comments.

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