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5 principles of strategic beta

Alex Prineas  |  08 May 2014Text size  Decrease  Increase  |  

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Alex Prineas is a Morningstar fund research analyst.


"Smart beta," "alternative beta," "enhanced indices," "fundamental indices" -- there's a list of monikers to describe the expanding middle ground between active and passive funds. The need to define this space, to measure it and to police it has grown and will continue to grow.

At Morningstar, we describe such strategies as "strategic beta" and our aim is to help investors better understand their uses.

Strategic beta aims to improve on traditional indexing, yet retain its transparency, low turnover, tax efficiency and low fees.

It is one of the fastest-growing sectors in the fund industry. As at 31 December 2013, Morningstar counted 342 strategic-beta exchange-traded products (ETPs) in the US, with US$291 billion of assets (nearly 18 per cent of the US ETP market). That was an increase in assets of nearly 59 per cent in 2013.

It's also popular in Australia. The segment has grown to A$1.158 billion in March 2014 from about A$690 million in March 2013. On our count, 14 ETPs (more than 10 per cent of Australian ETP assets) use strategic-beta approaches.

Active managers consider many factors but ultimately judgment is key. In contrast, on the passive side, traditional indices use rules, not judgment. The primary rule is market cap. Even if a company is expensive, if it's big, it should loom large in a market-cap-weighted index.

Strategic beta lies somewhere in between -- it is rules-based but goes beyond market cap. Other factors drive portfolio make-up, such as value, momentum, quality, volatility or income.

Take the Vanguard Australian Shares High Yield ETF (VHY). It grew from A$134 million in March 2013 to A$376 million in March 2014. Vanguard also runs a A$683-million fund equivalent -- Vanguard Australian Shares High Yield [6429]. Market cap plays a part in VHY's approach but rules slant the portfolio to high-dividend stocks.

The thirst for yield saw VHY vastly outperform the S&P/ASX 200 index in 2013 but this could easily reverse. Interest-rate rises could punish yield stocks, or VHY might invest in dividend traps that deliver a dividend cut and a possible capital loss.

There is no assurance that a focus on dividends delivers a higher total return. Nevertheless, VHY satisfies a demand for income with a transparent methodology at a competitive price.

Another approach is taken by Research Affiliates, which popularised the term "fundamental indexing" in the US. It focuses on fundamental value ratios: price/earnings, price/book, dividend yield and price/sales.

That methodology drives one of the most popular strategic-beta approaches in Australia -- Colonial First State's Realindex suite, which had about A$8.1 billion in assets at 31 December 2013.

The BetaShares FTSE RAFI Australia 200 ETF (QOZ), despite launching as recently as July 2013, has already gathered about A$30 million in assets by offering a similar Research Affiliates metholodogy through a low-priced ETF.