Smart Beta Replication Costs

An important issue with smart beta strategies is that they typically entail higher replication costs than cap-weighted market indices. 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. 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 by reporting gross returns, leaving it to other market participants to figure out what exactly the transaction costs amount to. This study sets out to apply methods for explicit cost measurement and to thus draw conclusions on smart beta strategies.