5 principles of strategic beta
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Morningstar's Alex Prineas argues there are five key principles that underlie good strategic-beta strategies--an area that will continue to need to be defined, measured and policed.
"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 also one of the fastest-growing sectors in the fund industry.
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). Market cap plays a part in VHY's approach but rules slant the portfolio to high-dividend stocks.
But there is no assurance that a focus on dividends delivers a higher total return. Interest-rate rises could punish yield stocks, or VHY might invest in dividend traps that deliver a dividend cut and a possible capital loss.
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.
The BetaShares FTSE RAFI Australia 200 ETF (QOZ) offers a similar Research Affiliates methodology through a low-priced ETF.
While there is substance to the strategic-beta trend, we advise caution.
Strategic beta aims to isolate the factors that produce returns and managers often point towards favourable back-testing--using past data to simulate future behaviour--for the factors they have chosen.
But factors that worked in the past may not deliver future success. Even truly predictive factors decay over time as rivals adopt them and arbitrage returns.
Momentum factors succeeded before the GFC but delivered disastrous results in 2008 as established trends abruptly reversed.
And many quality and value factors have diminished in worth as more investors use them (for example, interest cover, price/book).
In our opinion, a good strategic beta approach must involve five principles:
1) 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.
2) 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).
3) Capable people
Those behind the strategy must have an understanding of financial theory, market reality, as well as expertise in trading/execution.
4) 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 this regard.
5) 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.
Investors interested in strategic beta can find out more about individual strategies by reading Morningstar's fund analysis.More from Morningstar
Alex Prineas is a Morningstar research analyst.
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