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By Michael Rawson, CFA | 09-18-2014 04:00 PM

When Does It Make Sense to Use a Strategic Beta Fund?

Investors may consider four levers in allocating their portfolios between traditional index, actively managed, and new strategic beta funds, says Schwab's Tony Davidow.

Mike Rawson: Hi, I'm Mike Rawson with Morningstar. I'm here at the Morningstar ETF Conference. I'm joined by Tony Davidow. Tony is the alternative beta and asset-allocation strategist with Schwab Center for Financial Research.

Tony, thanks for joining me.

Tony Davidow: Thanks for having me, Mike.

Rawson: Tony, one of the biggest topics in the ETF industry today is this concept of smart beta. It's a term that Morningstar is calling strategic beta. When people talk about smart beta, what types of investments are they referring to?

Davidow: I applaud you guys because I think that in the industry there is a lot of noise around smart beta without a real understanding of how these strategies work--how they compare and contrast. And I think the way that we look at it is anything that is non-cap-weighted--whether it's something that reflects a value or growth intentional tilt built in, or strategies like equal weight, low volatility, or fundamental strategies.

And what we try to focus on is, although they're all broadly defined as alternative weighting or non-cap weighted, at the end of the day they are actually very different. And I liked your taxonomy, the way that you have described it, because I think it helps investors hopefully make better informed decisions.

Rawson: Tony, you mentioned this concept of non-cap weighted. What does that do for a portfolio? Let's say I take a group of stocks and I change their weighting where I'm not weighting them by their market capitalization, which is something a traditional index such as the S&P 500 would do. When I break that link between price and weight, what does it do to the portfolio? How should I expect that portfolio to behave?

Davidow: I think it's a great starting point because I think a lot of investors don't fully understand what they're buying when they buy a market-cap-weighted index. The largest companies have the largest weight. A lot of the returns are impacted by the performance of the biggest names in an underlying index. So, you're very much dependent on the largest capitalization stocks driving a lot of the excess return.

When you think of these other strategies--which are designed to break the link with price--what you find is, by breaking the link with price, you are actually providing a very different risk-return pattern over time and, based on research we've done, these fundamental index strategies in particular have generated fairly significant excess return across the variety of strategies.

Rawson: So, I think it can be intuitive for investors to understand that these strategies give you exposure to factors that have been associated with excess return in the past. We know value has worked, we know small size has worked historically. The hardest part, I think, is knowing how to use them in your portfolio, and you've done some work about how the investors' objectives can influence their decision about whether they should be using a traditional passive-investment product, a strategic-beta product, or a completely actively manage product. Can you talk about that work?

Davidow: Yes. And I think it's a great jumping off point because, for us, we do believe there is a role for active and passive strategies, and we do believe these next-generation fundamental strategies are evolutionary in nature and deserve a role in the portfolio. So, what we have done is we have come up with four key levers that investors can think about as they think about allocating across those strategies.

For those investors who are very concerned about loss, they may want overweight active management. And again, there's a lot of historical data showing that active managers have had a difficult time consistently outperforming. However, there are managers who can do a better job protecting. An active manager can take risk out of the portfolio when markets get difficult. So, we would argue an underappreciated value of active management is loss aversion, protecting losses.

If you're concerned about tracking error--in other words, being different than the benchmark--or you are primarily focused on costs, we would argue you might want to have a higher allocation to a market-cap strategy. By definition, they are going to give you a market experience, and they will be the lowest-cost solution in the marketplace.

However, for those investors who are really looking to get a better experience in the market and ideally they're trying to seek and identify alpha, fundamental strategies--based on the historical research we've done--generate excess return over time. So, we would argue loss aversion, tracking error, cost, and whether you're seeking alpha and beta are key factors to think about as you allocate across those strategies.

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