Origin Story

Verified Beta was founded by Andrew Jones, CFA, as an adjunct to his public and private company valuation practice, M&A advisory work, and role as a fractional CFO to scale-stage SaaS businesses. The need originates with asset allocation and portfolio optimization for independently-managed family assets. The initiative gives Andrew an excuse to return to his software engineering roots whilst keeping his analytical, research, and writing skills sharp. He loves this stuff almost as much as writing about himself in the 3rd person.

The Essential Problem

Equity ETFs marketed as Smart Beta have attracted over $1T of AUM. When filtering for funds in Verfiedbeta’s analysis of over 3000 US-listed ETFs that feature statistically-significant exposure to at least one of the well-researched ‘factors’ such as Value and are at least 2 years old, the total is over $3T of the $6T aggregate AUM.

The top few passive index funds have amassed roughly the other 50% of aggregate AUM in the US-listed ETF universe and are essentially free, charging just 1-3bps in total net fees. In stark contrast, Smart beta funds suffer fees and turnover-related trading costs on the order of 100 – 150 bps per year, or 30-50 times greater.

The expectation is that the contribution from Smart Beta factor exposure more than makes up for fees and trading costs. But how often is that actually true? How often are investors assuming that a so-called Smart Beta ETF really is a smart investment, when it might otherwise be a source of negative expected returns relative to a passive index fund? The waters are further muddied by the prospect that factor returns are unstable and likely decaying over time.

Finally, following the recently-ended macro economic epoch characterized by decade-plus-long near-zero interest rates and concomitant widespread distortions in fundamental value, how can we manage the risk that we’re not overpaying for equity ETFs writ large?

Our Solution

We systematically identify those funds that:

1. capture factor contributions projected to cover their management fees and implied trading costs;
2. have projected forward (ex-ante) Sharpe ratios superior to the market, based on real, measured, in-sample fund volatility and factor capture;
3. are presently composed of equities fairly-valued or inexpensive relative to their historical median valuation, in the aggregate.

Definitions

Throughout our fund analyses, we standardize core summary metrics defined as follows:

Process

We perform systematic, fund universe-wide regressions and then use back-tested synthetic fund performance to infer our best estimate of expected forward performance. We’ve standardized on the Fama and French 5-factor model plus momentum and refer to the model as FF6. Although the Q5 and AQR models appear to subsume FF6 in the GRS test for model superiority, we elect FF6 both because of its pervasiveness and its frequency of overlap with actual ETF product implementation. We summarize comparisons with the AQR and Q5 models where fund constitution criteria are aligned.

Stepwise (see Definitions for reference terms, above):

1. perform OLS linear regressions on monthly fund total return data to determine the best-estimate of historical factor capture (regression coefficients);
2. create a synthetic fund with equal factor exposure starting in July of 1963 (the first month of publicly-available FF6 data);
3. calculate the Implied Relative Factor Sharpe;
4. rank all funds in the universe to generate Factor Capture Score;
5. calculate the individual Factor Capture Scores;
6. calculate the Relative Valuation
7. summarize in Factor Tombstones, fund spotlight analyses, and our ETF Finder Tool

The Verifiedbeta Difference

It’s a one-two punch:

1. We summarize estimated risk-adjusted fund performance relative to to the historical return of a plain-vanilla market-cap-weighted passive index fund with a single metric: Factor Capture Score
2. We compare current fund valuation to historical valuation to help allocators avoid funds which are presently overvalued, expensive and potentially risky.