The Strategic Factor of Smart Beta

LOW COST FUNDS: Morningstar analysts say not all 'smart beta' strategies are smart. Instead these benchmark trackers should be called 'strategic beta'

Ben Johnson 13 June, 2014 | 12:26PM
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“Smart beta,” “alternative beta,” “enhanced indexes,” “quantamental indexes”—at this point, the list of monikers describing the fast-growing middle of the active-to-passive spectrum extends long enough to put it just a few syllables shy of making a lunar landing. It’s an arena that has further blurred the lines between active and passive management, and one which is at the leading edge of the most recent wave of product proliferation within the global exchange-traded products (ETPs) landscape.

What Morningstar is deeming strategic beta is a broad and rapidly growing category of benchmarks and the investment products that track them. The common thread 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 (see “Factors 101”).

As new products have continued to roll off asset managers’ assembly lines, their sales and marketing departments have been working tirelessly to position these new models within an increasingly competitive field. The result has been a ratcheting up of the level of complexity of the indexes that form the raw stuff of these benchmark-based investment products and, in some cases, a growing disparity between how they are pitched by their sponsors and the actual investment results that they produce. Investors are faced with a complex task as they navigate this landscape, and Morningstar is working to provide the compass they need to do so.

What’s in a Name?

The need to define this space, to measure it, and to police it has grown and will continue to grow with time. At Morningstar, we are positioning ourselves to meet these needs, with the goal of helping investors make better-informed investment decisions. For our part, we have decided to tag this realm with the label strategic beta.

Why strategic beta? First and foremost, we are eager to do away with the positive connotations 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 ETPs, 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 i.e. 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 one 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 description.

It should be noted that these are merely attribute tags and not new fund categories, just as we do not have a “passive” or an “active” category. The portfolios of strategic beta funds exhibit a variety of investment styles. Our purpose in creating these descriptions is to help investors rigorously analyse this breed of funds, facilitating comparisons between those with similar strategies as well as within the context of their traditional Morningstar category.

A version of this article originally appeared in the April/May 2014 issue of Morningstar magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.