As the universe of strategic-beta products continues to swell, it's refreshing to see some efforts being made to help investors and advisers understand how these strategies can be used inside portfolios as opposed to just pointing out how much better they are than traditional indexes.
Charles Schwab & Co. is making strides in that direction with a rudimentary — but effective — means of integrating strategic beta into portfolios that include active and index funds.
For starters, let's point out that the most important thing anyone needs to know about strategic beta funds is that they are not traditional market-cap weighted indexes.
Beyond that, all bets are off because strategic beta products (aka, smart beta, alternative beta, fundamental indexing, enhanced indexing, quantamental indexing, etc.) are as unique as they are plentiful.
In essence, these hybrids of indexing and quantitative active management products are not helping to shed a reputation of being overly complex by using a half-dozen different phrases to identify the category. But that's what happens when something starts to take off. And take off it has.
Morningstar Inc. counts strategic beta ETF assets at nearly $350 billion, up from $175 billion two years ago.
The growth is coming from a loyal but still largely concentrated following of new believers of diversifying away from the punishing math of cap-weighted indexed investing that includes automatically adding exposure to the highest value stocks.
“I understand that financial theory says market-cap weighting is correct, but financial theory represents the way things are supposed to work,” said Rob Arnott, chief executive of Research Affiliates, a pioneer in strategic beta strategies. “Think of a cap-weighted portfolio as having a growth tilt toward momentum and popularity.”
While it is easy to make the case against cap-weighted indexing, it doesn't automatically lead to a slam-dunk sale for strategic beta, primarily because strategic beta is represented by a very diverse mix of quantitative strategies.
As Morningstar's director of passive funds research Ben Johnson explained: “The common thread among them is that they seek to either improve their return profile or alter their risk profile relative to more-traditional market benchmarks.”
For example, the Direxion Nasdaq-100 Equal Weighted Index ETF (QQQE) offers equal exposure to each of the 100 underlying stocks in the index.
Across the universe of more than 400 strategic beta ETFs tracked by Morningstar, the specific emphasis can range from volatility to value bias.
Another way of looking at the differences between cap-weighting and strategic beta strategies is to consider the underlying exposures.
At the end of 2013, the traditional cap-weighted S&P 500 Index had a 9.8% exposure to consumer staples, which compares with 20.8% for the S&P 500 Low Volatility Index. On an equal-weighted basis, the same index had a 7.9% exposure to consumer staples.
The utilities sector stands out as an even more extreme example. The cap-weighted S&P had a 2.9% exposure to utilities in December, compared with 23.7% for the low-volatility index, and 6.1% for the equal-weighted S&P.
“We believe that alternative beta strategies can serve as a nice compliment to both market-cap and actively-managed funds,” said Anthony Davidow, vice president and asset allocation strategist at Schwab's center for financial research.
With that in mind, Mr. Davidow's team has developed some basic pie chart models and portfolio construction levers to help advisers to incorporate strategic beta into client portfolios.
The four key levers to determine where strategic beta might fit are tracking error, loss aversion, alpha and cost. Each lever is applied across a table that includes market-cap indexing, strategic beta and active management.
For example, if tracking the broad market indexes is a high priority with an investor, a portfolio should be more heavily allocated to a market-cap index and have a lower allocation to a strategic beta fund. If alpha is the main objective, strategic beta is the best option along with active management because the market-cap indexes are not designed to provide alpha.
Looked at another way, the Schwab pie-chart models offer general allocation suggestions for market exposure objectives.
Domestic large-cap growth, for example, would include a 50% allocation to strategic beta funds, 30% in market-cap indexes, and 20% in active funds. Emerging markets exposure, meanwhile would include 50% in active management, 30% in strategic beta, and 20% in market-cap indexes.
“We believe each style has a role in the portfolio, and each will have its day in the sun,” Mr. Davidow said. “I don't hear a lot of advisers saying they want to give up all together and allocate entirely to [strategic beta], but a lot of advisers just buy without thinking what they are getting with regard to cap-weighted indexes.”