"Smart-beta" strategies are index funds that attempt to beat the market or achieve specific objectives, like higher income or lower risk, through security selection, alternative weighting or some combination of the two. They express active bets, which go through stretches of strong and weak performance.
Financial advisers should understand the strategy, evaluate it as you would an active manager, and make sure your clients have the patience to stick with it. While some smart-beta funds have merit, not all do. Morningstar prefers to call smart beta "strategic beta" to remove the positive connotation.
Strategic-beta funds come in many flavors. Most target stocks with a common set of characteristics, or factors, that have historically been associated with market-beating performance. These include low valuations, strong recent performance (momentum), low volatility, high profitability and small market capitalizations. But that does not guarantee that all these funds will be successful.
Even funds that appear to target the same factor can look and perform quite differently, depending on how they measure the factor, how aggressively they pursue it and how they weight their holdings.
For example, iShares Edge MSCI USA Momentum Factor ETF MTUM targets stocks with strong momentum more aggressively than SPDR Russell 1000 Momentum ETF ONEO. As a result, it includes around 125 stocks, whereas ONEO has closer to 900. This gives MTUM stronger exposure to the momentum factor, which opens up greater upside potential but also increases risk.
Funds that apply more stringent selection criteria, often reflected in more concentrated portfolios and greater tracking error, tend to offer more potent exposure to the factors they target.
The best strategic-beta funds are cheap, transparent, effectively capture the factor(s) of interest and take steps to mitigate unnecessary turnover and risk, such as large sector or country concentration.
Strategic-beta funds tend to charge more than traditional index funds, but investors shouldn't pay a high premium for them. These are rules-based strategies that do not require any more human intervention than an S&P 500 tracker. Fortunately, many strategic-beta funds charge less than 0.30%, which is competitive with the lowest-cost index funds.
Transparent index construction methodology can inform whether a fund will likely provide efficient exposure to the factor(s) it targets, as can its portfolio composition and performance record.
For example, iShares Edge MSCI USA Quality Factor ETF QUAL targets stocks with high return on equity, low debt/capital, and low variability in earnings growth relative to their sector peers. If it's effective, it should favor more profitable companies than average and tend to outperform during market downturns. While this fund hasn't been tested in a major market downturn, it exhibits the expected profitability tilt.
It is important to be mindful of the unintended bets that a strategic-beta fund might introduce. QUAL's sector-relative selection approach helps mitigate sector tilts. In contrast, PowerShares S&P 500 Quality ETF SPHQ does not constrain its sector weightings, which are sources of active risk ancillary to the quality factor.
No factor will work well in every market environment, but factor strategies can complement one another. For example, value tends to work well when momentum doesn't, and vice versa. A diversified portfolio can be done by investing in a few single-factor strategies, or by selecting an integrated multifactor fund.
While both approaches dilute the portfolio's exposure to each factor, the latter can offer slightly stronger exposure to the factors of interest. This type of fund doesn't necessarily own the stocks that look the best on any single metric, but targets those with the best overall combination of characteristics.
Bronze-rated iShares Edge MSCI Multifactor USA ETF LRGF is one of the most promising multifactor strategies. It targets stocks with a strong combination of value, momentum, quality, and smaller size characteristics while constraining the portfolio to limit unintentional sector bets and turnover. This strategy was launched in April 2015, but its holistic approach to portfolio construction and low 0.20% expense ratio give it a good chance to succeed.
Not all strategic-beta funds are worth investing in, but the ones that are offer transparency, sensible portfolio construction and reasonable fees. Even the best strategies won't work all the time. Diversifying across factor strategies can help reduce risk and make it easier to stick with them over the long term, which should improve odds of success.
Alex Bryan, CFA, is director of passive strategies for North America at Morningstar.