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By Christian Charest and Ben Johnson, CFA | 10-03-2013 04:00 PM

Intelligence of 'Smart' Strategies Open to Question

Due diligence is required when examining the potential value of smart beta strategies, but there is room for innovation, particularly with fixed-income indexes, says Morningstar's Ben Johnson.

Christian Charest: We're coming to you today from the Morningstar ETF Invest Conference in Chicago. I'm here with Ben Johnson. He is the director of passive funds research at Morningstar.

Now Ben, earlier today, you moderated a session titled the "New World Order of Indexing." The panel was made up of three representatives from major index providers, and there were some interesting discussions on some of the innovation that's happening in the indexing industry and how that translates into the ETF world.

One of the innovations that was mentioned was so-called smart beta, or factor-based indexing. The panelists seemed to have some reservations about those types of strategies.

Ben Johnson: Yes. I think those reservations really are not shared just by the panelists, I share them myself. The term "smart beta" has certain positive connotations to it that I think are somewhat undeserved. And also implicitly, you would think that if these new smart beta strategies are smart that, it would then imply that everything that came before them was in some way dumb, which is certainly not the case.

The smart moniker, I think, has really caught-on to describe this space. But I don't think it's an apt name. I think it's incumbent upon investors to really parse these strategies, these indexes to be able to decide for themselves, which ones are truly intelligent and which ones may be in some cases, the product of back testing and data mining and an over fitting of data. So I think there is a due-diligence burden that's really presented itself as this space has grown.

Charest: Now terminology aside, what was the consensus about the value of those strategies among the panelists?

Johnson: I think it's generally that there is value there. I think if you look at really all the way back to the academic literature where the concept of factors and the distilling of factors and the testing of factors over time and their contribution to investor returns or investment returns began and then into practice, there are essential elements that form the basis of investment returns that can be isolated, be it value or size or momentum.

I think there is a general consensus that there is value there. There are different ways, though, to get at that value and to create indexes that look to target these specific factors. Again, that's really where the burden and the due-diligence is necessary. To look at these similarly labeled, almost seemingly like-for-like products, peel back that label on the tin to see really what's contained in the underlying index and what it's really exploiting.

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