The True Cost of Smart Beta

New forms of passive investing haven’t brought down costs—in fact, some providers may be charging a premium for their “innovation,” Morningstar says.

Exchange-traded fund (ETF) providers may be charging an innovation premium on smart beta products, according to analysis by Morningstar.

“The complexity of underlying strategies will continue to be leveraged by providers as a justification for premium prices relative to more vanilla fare.”Such strategies—which the fund analysis group calls “strategic beta”—can be up to three times more expensive than traditional index funds. However, there was little justification for the higher fees beyond a lack of pricing pressure, Morningstar claimed.

“The higher fees taken by strategic beta ETFs can be simply explained by the fact that these funds offer ‘new’ and ‘innovative’ strategies,” wrote Morningstar’s Ben Johnson, Hortense Bioy, and Dimitar Boyadzhiev. “ETF providers leverage this ‘newness’ and ‘innovation’ to justify premium pricing, no different from any other product in any other industry at the early stage of its life cycle.”

However, the costs of building and managing smart beta benchmarks were “not significantly greater than those incurred in constructing and calculating a broad market cap-weighted benchmark,” the trio said. “Thus, it is difficult to justify the incremental cost.”

ETFs using the S&P 500 as a basis for their smart beta benchmarks were on average three times more expensive than market cap-weighted equivalent funds, Morningstar found. The group said this was likely due to the intense pricing pressure on traditional passive strategies.

The premium pricing for smart beta could allow providers to “regain some of the profit they have lost as a result of the fee cuts within their core offerings in an attempt to attract assets,” the analysts said.

Despite the high costs relative to market cap-weighted strategies, Morningstar’s research found that Europe-based ETFs were getting cheaper on average. However, the authors said this was due to cheaper products being launched, rather than price cuts for existing funds.

Investors in smart beta funds should be aware that fees “are the greatest predictor of future performance,” the trio added, as low-cost products “have greater odds of future success.”

“The ever-growing complexity of the underlying strategies will continue to be leveraged by index and ETF providers as a justification for premium prices relative to more vanilla fare—whether warranted or not,” the report concluded.

Morningstar analyzed 100 European-domiciled smart beta ETFs for its report, “Assessing the True Cost of Strategic Beta ETFs.

Related: Too Many ETFs ‘Spoil Low Costs’ & Smart Beta’s Takeover