Most strategic-beta funds' performance can be replicated with a combination of market-cap-weighted indexes.
A Better Way to Invest?
Most equity strategic-beta funds attempt to outperform traditional market-cap-weighted indexes through security screening, alternative weighting, or some combination of the two. These funds are often positioned as differentiated strategies with fees to match.
Yet, many of these funds simply overweight smaller and/or cheaper stocks, and investors could obtain these tilts more directly with market-cap-weighted index funds that target specific segments of the Morningstar Style Box. This leads to an important question: Can investors replicate strategic-beta funds' performance with a combination of market-cap-weighted indexes? The answer will help investors evaluate whether it is worth paying up for strategic-beta funds.
This study compares the performance of each strategic-beta fund against a replicating portfolio of six style benchmarks for its relevant universe, as shown in Exhibit 1. These replicating portfolios serve as custom benchmarks for each fund. They assign weightings to the underlying indexes that yield a portfolio whose monthly returns would have most closely mimicked those of the fund.
The purpose of these replicating portfolios isn't necessarily to recommend a substitute for the strategic-beta funds. In many cases, that wouldn't be practical because the precise weightings of the replicating portfolios are unknown ex ante, and they may shift over time. However, this analysis provides insight into whether strategic-beta funds provide exposure that's distinctive from a combination of various cap-weighted indexes.
While the CRSP U.S. indexes underpin a suite of low-cost Vanguard exchange-traded funds, there are no funds that track the foreign developed- or emerging-markets indexes listed in Exhibit 1. So, it isn't feasible for fund investors to gain access to the replicating portfolios outside the United States. It is important to note that the replicating portfolios used in this study are based on index returns and do not take fees into account.
This study included all equity exchange-traded and open-end funds tagged as "Strategic Beta" in Morningstar's database, excluding market-cap-weighted value and growth funds, that were around at the beginning of June 2007 in the U.S. equity Morningstar Categories shown in Exhibit 2. I then created a replicating portfolio for each fund based on its performance during the next 10 years. The survivorship rate in each category was 100% during this span.