Investors will be able to assess net returns arising from smart beta strategies through a new transaction cost measurement approach put forward by a research paper from EDHEC Risk Institute.
Currently, smart beta providers do not routinely report transaction cost estimates for their strategies, and performance evaluation often relies on simulated gross returns, the research said.
“A reasonable expectation from an investor’s perspective is that providers should disclose the level of transaction costs generated by their strategies so as to allow for information on net returns,” the paper said.
The paper – ”Smart Beta Replication Costs” – was written by Edhec researchers Mikheil Esakiais, Felix Goltz, Sivagaminathan Sivasubramanian, and Jakub Ulahelis.
Edhec said its research provided an “explicit estimate” of costs applied to a range of strategies and showed the impact of using different implementation rules or stock universes.
Among the major findings highlighted by the authors, the paper found that conclusions about transaction cost levels and strategy implementation challenges were heavily dependent on the stock universe under consideration.
The researchers also found that, for commonly used beta indices built on liquid universes and integrated implementation rules, the impact of transaction costs on returns was small. These costs did not cancel out the relative return benefits over cap-weighted indices.
A key issue with smart beta strategies was that they typically entailed higher replication costs than cap-weighted market indices, the researchers said.
“While this is obviously true, the crux of the question is not whether transaction costs are higher but whether, after accounting for such costs, there are any benefits in terms of net returns,” they said.
The study noted that while the importance of accounting for transaction costs in the evaluation of smart beta strategies was not doubted, relatively little was known about the magnitude of these costs.
As a result, there was limited information related to the impact of implementation aspects – such as the selection of a liquid universe or turnover controls – on transaction cost levels.
Lionel Martellini, director of Edhec-Risk Institute, said the results of the paper provided an important contribution to the analysis of smart beta strategies from a practical perspective.
“Moreover, the methods we use are not computationally intensive and they draw on easily available data, making them easily replicable for practitioners who wish to analyse smart beta strategies,” he added.
Given its “transparent methodology and benign data needs”, Edhec said its replication cost analysis could be easily applied to other strategies.
The study was conducted as part of the Amundi research chair at EDHEC-Risk Institute on “ETFs, Indexing and Smart Beta Investment Strategies”.
The full paper is available here.