Scientific Beta

This paper provides an explicit estimate of the costs applied to a range of smart beta strategies and analyses the impact of different implementation rules or stock universes. The objective is to assess transaction costs of smart beta strategies in order 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.

This paper provides an explicit estimate of the costs applied to a range of smart beta strategies and analyses the impact of 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 often fail to make explicit reference to transaction costs and simply report gross returns, leaving it to other market participants to figure out the exact amount of transaction costs.

The objective of this paper is to assess transaction costs of smart beta strategies in order 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: the authors find that conclusions about transaction cost levels and strategy implementation challenges are heavily dependent on the stock universe under consideration;
   
• Practical implementation rules effectively ease liquidity and cost issues: the 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.