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Tuesday, March 1, 2016

Strategic Beta of Mutual Funds

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"Smart beta," "advanced beta," "alternative beta," "enhanced indexes," "strategy indices," "quantamental indexes"—are the list of monikers describing the intersection of active and passive investing.

We refer to smart beta as strategic beta.

What Morningstar deems as strategic beta is a broad and rapidly growing category of benchmarks and the investment products that track them. The common thread among them is that they seek to either improve their return profile or alter their risk profile relative to more-traditional market benchmarks. In the case of equity products, which account for the overwhelming majority of assets in this arena, the result is typically one or more factor tilts relative to standard market indexes.

Why strategic beta?

First and foremost, we are eager to do away with the positive connotations that may be inferred by the "smart" in smart beta. Not all of the strategies included in this arena are smart, per se.

The term strategic is meant to draw attention to the fact that the benchmark indexes underlying the exchange traded products, mutual funds, and other investment products in this space are designed with a strategic objective in mind. These objectives primarily include attempting to improve performance relative to a traditional market-capitalization-weighted index or altering the level of risk relative to a standard benchmark.

As for the beta in the name, it is not meant to imply beta in the strictest, most academic sense of the term (a measure of a security or portfolio's sensitivity to movements in the broader market). Instead, it is to highlight the fact that this is a group of index-linked investments, all of which have the goal of achieving a beta equal to 1 as measured against their benchmark indexes. Strategic beta may not roll off the tongue as easily as smart beta, but we believe it is a more accurate descriptor--one that doesn't imply that this universe is the index world's equivalent of Lake Woebegon.

A good strategic beta approach must involve five principles:

  • Low cost

An absence of stock-forecasting or macroeconomic predictions means a large investment team is not required. A straightforward approach should cost little more than passive indexing. More complex strategies may be priced at a premium but should still be cheaper than active management.

  • Sensible index construction

The factors selected must be well-considered. They should be either durable predictors of return, or if not durable, there must be scope to adjust factors over time in a transparent way. Alternatively, factors may not target outperformance but some quality of return that investors demand (for example, high income or low volatility).

  • Capable people

Those behind the strategy must have an understanding of financial theory, market reality, as well as expertise in trading/execution.

  • A wide investment universe

An advantage of strategic beta is the ability to use computers to process a wide array of information. For example, RealIndex can quickly compare the price/book and price/earnings ratios for every major stock in the emerging markets universe. If there is only a small universe, or the universe is skewed, active managers may be better equipped. The Australian market, dominated by a handful of banking and resource stocks, is vulnerable in that regard.

  • Good data

Strategic beta is only as good as the quality of the data. Accounting data (for example, sales and balance sheet figures) can vary greatly. Data must be consistent across countries and industries, or alternatively, it must be rigorously standardised.

A number of strategic-beta approaches have long track records of success and we agree there is some logic to constructing indices using factors beyond just market cap. After all, just because a company is big does not necessarily mean it's a good investment.

But investors must understand what they are buying and why. Strategic beta is not a panacea and inevitably these strategies will go through difficult periods. For example, income-biased strategies will suffer if high-dividend stocks underperform. Value strategies may suffer when the economy is weak or when risk aversion spikes. But given strategic beta's relative transparency, investors should have little to complain about so long as they have done their homework.

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