This article is part of Morningstar's Guide to Passive Investing, helping investors make smart choices to meet their long-term investment goals.
Smart beta is a growing category of indexes – and exchange traded funds that track them – which seek to enhance returns or minimise investment risks relative to a traditional market capitalisation-weighted benchmark.
Others seek to address drawbacks of standard benchmarks, such as the overweighting of the most-indebted issuers in market-cap-weighted fixed-income benchmarks.
These ‘smart beta’ ETFs are weighted by alternative variables such as dividend payments, volatility and earnings and exploit the same sources of return as active managers.
“This category represents a middle ground on the active-to-passive spectrum,” said Morningstar managing director Simon Ewan.
“Smart beta deviates from a traditional strictly passive market portfolio – but doing so in a rules-based, transparent and relatively low-cost way.”
Ewan and the Morningstar passive fund analysis team think the name ‘smart beta’ is confusing and instead prefer the phrase ‘strategic beta’ as it more accurately describes how investors use these ETFs.
This market has grown rapidly, as both retail and institutional investors cotton on to the benefits of getting active-management like returns, at passive management prices.
In recent years, the space has grown more rapidly than the broader ETF market as well as the asset management industry as a whole. As of June 30, 2016, there were 1,123 strategic-beta ETPs, with collective assets under management at approximately $550.5 billion worldwide.
The pace of new product launches has accelerated to record levels. The number of strategic-beta ETFs listed globally increased by more than 23% versus June 2015. This mostly due to a record number of new launches in the US.
Dividend-weighted ETFs continue to be the most popular grouping of strategic-beta ETPs in all but one region we examined. This should come as little surprise when considered in the context of the prevailing interest-rate environment.
Timing is Everything
But Ewan warned that it is not enough simply to chuck cash at these products, as with active management, timing is of the utmost importance.
“It is not enough to simply choose not to outsource stock selection – you still have to time the market well if you want positive returns,” he said.
“Strategic beta ETFs transfer the risk of the investment decision form the active manager to the investor. It is therefore an active decision even if implemented passively.”
He added: “A good active manager will always justify their fee.”
Investors should be aware that strategic beta strategies will go through periods of underperforming the stock market, due to omissions or tweaks made to their composition, and can be more volatile if weighted by certain variables.
Ewan advised that investors needed robust governance and discipline when using these strategies and for the best returns should take a long term view and consider a multi-factor approach.
“This builds resilience and diversification into a portfolio,” he said.
