Unless you've been actively trying to avoid them, you've probably heard about strategic – or ‘smart’ – beta funds more than once or twice. These index-linked investments focus on one or more "factors" or attributes in an effort to improve their returns or alter their risk profiles relative to traditional market benchmarks.
Strategic beta strategies are being executed via the ETF format and have exploded in popularity: By the end of 2014, more than $400 billion rested in strategic beta ETFs globally, representing a significant chunk of the $2 trillion ETF market.
Advocates say that strategic beta funds are low-cost entryways to specific investment tilts that were previously available only through higher-priced actively managed funds. Some financial heavyweights think these funds can be useful if understood and used correctly. Others view strategic beta funds with scepticism.
Before considering whether or not strategic beta funds should be part of your tool kit, understand these basics.
1) Strategic Beta Funds Are Active-Passive Hybrids
Morningstar analyst Mike Rawson has called strategic beta funds "index funds that make active bets." Morningstar defines strategic beta funds as index funds that attempt to improve upon the risk or return characteristics of traditional indexes, such as the S&P 500 or FTSE 100 Index.
Strategic beta funds seek to boost return or dampen risk by tilting toward one or more factors. What's a factor? "A working definition of a factor is an attribute of an asset that both explains and produces excess returns," says Morningstar ETF Investor editor Sam Lee.
Some well-known factor-based approaches are value investing, growth investing, or small-cap investing. A strategic beta fund is an index fund that uses one or more factors in its methodology in a systematic, rules-based way--blurring the line between active and passive investing.
2) Strategic Beta Funds Have Been Around Longer Than You Might Think
As Morningstar director John Rekenthaler has noted, there has been a long-standing debate about where the line between active and passive funds should be drawn.
"It began when Dimensional Fund Advisors launched its first fund in 1981," says Rekenthaler.
Unlike other index-fund providers, DFA built its own indexes based on factors. Simply put, DFA was doing strategic beta before strategic beta was cool--or even coined as a term, for that matter.
The first strategic beta ETFs debuted in 2000 in the US. In fact, more than 60 strategic beta ETFs will have 10-year records by the end of 2015; another 147 will have at least five-year records by end of year. Passing these milestones has played a part in the recent growth of strategic beta funds.
“It is only natural for investors to want to evaluate a live performance record before investing,” says Rawson. He adds that these longer-tenured funds, as a group, have done reasonably well on a risk-adjusted basis.
3) Strategic Beta Funds are Becoming Increasingly Complex – and Tougher to Evaluate
The earliest strategic beta funds were pretty plain-vanilla, focusing on straightforward style tilts, such as value, growth, and small caps. Then, more-complex strategies came to market, including PowerShares' country- and sector-focused funds, WisdomTree's dividend-focused strategies, and First Trust's suite of sector, style, and country offerings.
Today's newest strategic beta funds trend toward strategies that blend several factors.
As strategic beta funds become more complex, so, too, does the process of evaluating them. As Morningstar analysts noted in the white paper they released last autumn on strategic beta; “Investors' due-diligence processes for these funds need to be every bit as rigorous as those they would undertake in scrutinizing active managers.”
The white paper notes that, thus far, investors have generally gravitated toward the more straightforward strategies, such as value, growth, and dividend-screened methodologies.
4) Some Strategic Beta Strategies are Likely to be Repeat Outperformers
The idea behind strategic beta is that investors can invest in a series of factors that have proven to outperform or reduce risk. But some factors are more ‘proven’ than others.
"Some betas – or factors – are well grounded in economic and/or behavioural patterns,” notes Rekenthaler.
"That is, they are associated with real risks, which is why they offer real and ongoing higher returns.”
In addition, academic research has been following many of these time-tested factors for decades. Factors that Rekenthaler expects to be repeatable are liquidity and value.
Some of the newer multifactor strategies do not have the same academic and behavioural underpinnings. And as Morningstar analysts noted in their white paper, some of these funds track benchmarks that have short track records and were designed for the sole purpose of serving as the basis of the ETF.
5) Strategic Beta Funds Require More Patience than Standard Index Funds
Academic research has shown that some of these factors have tended to outperform over long stretches of time – in some cases, very long stretches. "These stretches of time, I think, in many instances, are far in excess of your average investor's own time horizon," explains Morningstar research director Ben Johnson.
Therefore, it's important that potential investors in strategic beta funds appropriately manage their performance expectations from these investments. Particular factors can remain out of favour for a long while. To benefit from the factor, investors need the right time horizon.
6) Some Strategic Beta Funds are Cheaper Than Others
As Morningstar analysts noted in their white paper, strategic beta funds, on average, levy about the same expenses as the ETF industry at large. Nevertheless, there can be significant differences in price from fund to fund.
In Morningstar's ETF Analysts Reports, analysts discuss an individual fund's fees in-depth and also provide less-costly but similar alternatives where available. You can also find an ETF's expense ratio on the fund's page, or you can screen ETFs by expense ratio using Morningstar's ETF Screener.
Conclusions
By offering direct exposure to a variety of factors in a low-cost way, strategic beta funds are valid investment options for many investors. As with any investment, Morningstar recommends that you look beneath the hood and understand the factor or factors involved, the historical record or risk and return, and the expenses of any strategic beta fund you consider.
As analysts noted in the white paper, strategic beta funds compete against both active and traditional index funds; they should, therefore, be evaluated within this broader opportunity set. And as Johnson notes, some of these funds are "longer on marketing than they are on investment merit."
