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3 strategic beta ETFs and 5 top tips

Morningstar staff  |  16 Jun 2017Text size  Decrease  Increase  |  
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While traditional exchange-traded funds continue their rapid growth, this newer breed of exchange-traded products is gaining its own momentum.


Strategic beta exchange-traded product (ETP) funds under management has grown to just under $2.3 billion as at the end of March 2017, up from $250 million in March 2012--five years earlier, according to Morningstar data.

Bridging the gap between fully active management and index investing, strategic beta is known by various names.

Some call it "smart beta", others know it as "alternative beta", "enhanced indices" or "fundamental indices". Whatever it's called--and at Morningstar we call it "strategic beta"--it is one of the fastest-growing sectors in the fund industry.


Traditional ETFs growing fast, but a new breed of ETPs are gaining momentum
Australian ETP Market Growth, March 2010 to March 2017. Traditional ETFs, Active ETPs, Strategic Beta ETPs, Other Non-Traditional ETPs.


The "non-traditional" band here includes commodity ETPs, geared, inverse and derivative strategies, currency ETPs, ethical ETFs, and systematic strategies that do not track an index.
Source: Morningstar Direct, Morningstar ETFInvestor


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.
Strategic beta lies on the continuum between active management and passive management.

According to Alex Prineas, Morningstar's associate director, passive strategies: "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."

He refers to the Vanguard Australian Shares High Yield ETF (VHY) as an example of a strategic beta ETF, where other factors drive portfolio make-up, such as value, momentum, quality, volatility or income.

"Market cap plays a part in VHY's approach, but rules slant the portfolio to high-dividend stocks," Prineas says.

However, he emphasises "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."

BetaShares FTSE RAFI Australia 200 ETF (QOZ) follows a different approach, which is often known as "fundamental indexing" in the US.  This focuses on fundamental value ratios: price/earnings, price/book, dividend yield and price/sales.

A quality approach is yet another approach, as distinct from value and growth investing. Quality assessments of assets are made based on soft criteria--such as management credibility--and hard criteria--such as balance sheet stability.

VanEck Vectors MSCI World Ex-Australia Quality ETF (QUAL) is an exemplar of this approach. QUAL’s scale allows VanEck to buy all the stocks in the MSCI World ex-Australia Quality Index--a subset of the broader MSCI World ex Australia Index. MSCI targets firms with high return on equity, stable earnings growth, and low financial leverage.
However, there are many ways of defining and incorporating quality.

"VanEck faces tough competition, with active managers having greater flexibility in the way they harness quality," Morningstar manager research analyst, Anshula Venkataraman. However, she emphasises that active management "comes with a higher price tag".

"Quality has done well over multiple periods, but investors should be careful not to extrapolate past returns. This passive strategy has some merit nonetheless," she says.

Prineas echoes this view, reminding investors that "while there is substance to the strategic-beta trend, we advise caution," says Prineas.

He explains that 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," Prineas says.

Five top tips

Prineas believes a good strategic beta approach must involve five principles--all of which underpin Morningstar's research, which is available exclusively to Morningstar subscribers.

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. 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.

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