A recent Columbia Business School research paper looks into the transaction costs associated with smart beta strategies in order to estimate the capacity of each strategy.
The three authors of the report are all affiliated with asset manager BlackRock Inc. They are: Ronald Ratcliffe, Paolo Miranda, and Andrew Ang.
Ratcliffe et al begin with the observatin that smart beta strategies are hot. In April last year Morgan Stanley reported that total assets under management for the U.S. smart beta ETF market have been growing at the rate of 30% a year in recent years, and have reached $225 billion. BlackRock’s own forecast is that this market might reach an AUM of $1 trillion by 2020.
The idea of the ETFs is to give ordinary retail investors access to factor investing, so they can gain the premiiums associated with, say, momentum, or minimum volatility.
A Literature Gap to Fill
The BlackRockers naturally wonder whether this rate of growth is sustainable, or whether and when the trend will hit capacity limits. These questions, they say, “are especially relevant given that the vast majority of a large academic literature studying these style premiums has done so without taking transaction costs into consideration.”
Ratcliffe et al employ a transaction cost model developed in-house, used by the investment teams in BlackRock on a day-to-day basis.
They define the capacity of a smart beta startegy as “the breakeven hypothetical AUM at which the associated turnoer transaction costs exactly offsets the hiostorically observed style premium.” Beyond that, presumably, the premium has turned into a negative, a transactional discount. They make certain simplifying assumptions n the course of determining this hypothetical point, and they set aside “other restrictions that may limit capacity, such as maximum percentage ownership in a particular stock.”
Ratcliffe et al find that the strategy with the smallest capacity is that based on momentum. If trading is presumed to occur over one day, the estimated breakleven poiint for a momentum strategy is only $65 billion: if trading can take place over five days, the capacity increases to $324 billion.
Size Wins the Race
The most capacious strategy, that is, the one allowing the most room for growth, is that employing the size premium. This has a one-day breakeven point at $5 trillion, and with a five day trading horizon this goies to abve $25 trillion.
The corresponding figures for each of the strategies considered are as follows (I’m including here figures from both Exhibit 3 and Exhibit 6 of the Ratcliffe et al paper):
All figures in US$billions
Source: R. Radcliffe, P. Miranda, A Ang, “Capacity of Smart Beta Strategies: A Transaction Cost Perspective,” Columbia Bus. Sch. Research Paper No. 16-76
An Appendix on Definitions
For ease of reference, here is a refresher (paraphrasing one provided as an appendix within the paper) as what each of the six studied factors means, using the MSCI Smart Beta Indices as lodestone:
Momentum: the performance of U.S. large and mid cap stocks exhibiting relatively high price momentum, and maintaining at the same time liquidity, investment capacity, and moderate turnover.
Quality: the performance of U.S. large and mid cap stocks as identified through return on equity, earings variability, and the debt-to-equity ratio.
Value: the performancer of U.S. large and mid weighted stocks as identified by book value to price, 12-motnh forward earnings to price, and dividend yield.
Size: the performance of U.S. large and mnid-cap stock but tilted toward the smaller and lower risk stocks within that space.
Minimum Volatility: the performance of U.S. large and mid-cap stocks that have, in aggregate, lower vol characteristics than the broad U.S. equities market.
Multi-factor: the performance of U.S. large and mid-cap stocks focusing on financially healthy firms, inexpensive stocks, smaller companies, and momentum.
The Bottom Line
The bottom line is that the “capacity in smart beta strategies is large.” The growth of the market is not in imminent danger from these limits.