Smart beta may be the darling of (some of) the institutional investment world, but its costs are yet to be fully appreciated—at least according to a new paper by Research Affiliates.
Michael Aked, director of product design, and Max Moroz, head of investment systems, found that alternative beta strategies can have a greater impact on the pricing of securities than traditional index trackers, depending on their investment universe.
In their paper, “The Market Impact of Passive Trading”, the authors created a mathematical model to calculate market impact cost—the effect on individual security prices of bulk trades, in this case by passive investors.
The authors compared nine portfolios of 1,000 stocks each: capitalization-weighted, equal weighted, and “fundamental” (weighted by an average of book, sales, dividend, and income), for the US, developed markets excluding the US, and emerging markets.
The study found that the biggest factors affecting the market impact cost were the size of the fund relative to its index’s daily trading volume, turnover, and how far the strategy deviates from its benchmark.
Aked and Moroz’s model predicted that “at the same asset size, the market impact cost of rebalancing a broad fundamental US index is almost three times greater than that of a broad US cap-weighted index.”
Emerging markets had the highest market impact measures from the Research Affiliates model, regardless of weighting method. The authors said this was in part due to “higher idiosyncratic volatility” in these markets.
Aked and Moroz pointed out that their model had not taken into account trading strategies employed by some fund managers to mitigate the impact of rebalancing on securities pricing.
Financial regulators have pledged to place more scrutiny on smart beta strategies and indexes as the popularity of such methods has grown. At the start of this year, the US’ Financial Industry Regulatory Authority said products tracking “alternative” indexes “may be thinly traded and have wide bid-ask spreads, making these funds more costly to trade, in addition to their generally higher expenses.”
Related: Is Smart Beta Safe? Regulators Set Sights on New Indices & What Does It Take for Smart Beta to Be Successful?