6 Must-Knows About Strategic Beta Funds

Includes: IWD, IWF, JPGE, VTV
by: Morningstar

By Susan Dziubinski

Note: This article is part of Morningstar's April 2015 Active, Passive, and In-Between special report.

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, 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 notables, including investment expert and author Rick Ferri, think these funds can be useful if understood and used correctly. Others, such as Jack Bogle, view strategic beta funds with skepticism.

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 Russell 2000 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 ETFInvestor 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 and 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 - iShares Russell 1000 Growth (NYSEARCA:IWF) and iShares Russell 1000 Value (NYSEARCA:IWD)--debuted in 2000. 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 Dynamic and RAFI funds, WisdomTree's dividend-focused strategies, and First Trust's AlphaDEX suite of sector, style, and country offerings.

Today's newest strategic beta funds trend toward strategies that blend several factors. Examples include State Street Global Advisors' ETFs linked to MSCI Quality benchmarks and JPMorgan Diversified Return Global Equity ETF (NYSEARCA:JPGE), which tracks the FTSE Developed Diversified Factor Index.

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 fall 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 more grounded in economic or behavioral patterns - and are, therefore, more likely to be repeat outperformers - than others.
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 behavioral 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 behavioral 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 favor 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.

One of strategic beta's elder statesmen, iShares Russell 1000 Value, is a case in point. In his analysis, analyst Alex Bryan notes that the fund offers great liquidity, but with a 0.20% expense ratio, it's not the cheapest way to get exposure to this factor. "Vanguard Value ETF (NYSEARCA:VTV) offers similar exposure for 0.09%," writes Bryan.

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."

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