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Indexes and Benchmarking - March 01, 2017

Smart Beta Replication Costs

This paper provides an explicit estimate of costs applied to a range of strategies and shows the impact of using different implementation rules or stock universes.

A reasonable expectation from an investor’s perspective is that providers should disclose the estimated level of transaction costs generated by their strategies so as to allow for information on net returns. However, providers typically fail to make explicit adjustments for transaction costs and satisfy themselves with reporting gross returns, leaving it to other market participants to figure out what exactly the transaction costs amount to.

The objective of this paper is to assess transaction costs of smart beta strategies so as to contrast the gross returns of such strategies shown in backtests with estimates of net returns that are actually available to investors when considering transaction costs.

In terms of replication costs estimates that result from applying our methodology, three major findings can be highlighted:

  • Transaction costs and implementation challenges crucially depend on the stock universe; authors find that conclusions about transaction cost levels and strategy implementation challenges are heavily dependent on the stock universe that is used.

  • Practical implementation rules effectively ease liquidity and cost issues: authors provide evidence of the usefulness of practical implementation rules. Results suggest that whether or not smart beta strategies face implementation hurdles depends on the set of implementation rules that have been included in the design.

  • Smart beta performance benefits largely survive transaction costs: when looking at commonly used smart beta indices that are built on liquid universes and integrate implementation rules, the impact of transaction costs on returns is small, far from cancelling out the relative return benefits over cap-weighted indices.

This research was supported by Amundi ETF, Indexing and Smart Beta as part of the research chair at EDHEC-Risk Institute on “ETF and Passive Investment Strategies.