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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.

Charest: You asked the panelists whether there was still room for more innovation. Obviously, they are all index providers, so they wouldn't say that, no, the market is saturated. But I got the feeling that there was a little bit of awkwardness in their answers. The answers that they provided as far as their suggestions for possible innovation all seemed to revolve around details rather than major novelties.

Johnson: Yes. I think if you look at especially the legacy, plain-vanilla, market-cap-weighted space--if you think of an old stereo receiver, a lot of the crude-tuning has been done and now it's more a matter of fine-tuning. I think the most recent debate in terms of crude-tuning was around free-float market-capitalization weighting, so weighting based on the actual free float of the underlying constituents. Many stocks can have a, say, large private or government ownership component and weighting based on the 50% of that stock that might actually be freely available to the public. That was sort of the last great battle, the last great stand in terms of convergence of really the fundamental principles of index construction in the market-cap-weighted space.

Now to your point, it's focused very much on the fine details, things like investability and turnover, and it becomes difficult as you're increasingly splitting hairs to really gauge what sort of value those incremental improvements or innovations are having.

Charest: Now I'm going to put you on the spot a little bit and ask you as an analyst, where do you think the innovation is going to come from or if there actually is room for innovation at all?

Johnson: I think there is still room for innovation, but I don't think it's going to happen in the traditional market-cap-weighted space. I think one of the areas that really is right for innovation, is the fixed-income space, in fixed-income indexes. If you look at the composition of a lot of the major fixed-income indexes today, a lot of the talk--and it's very warranted--is that these in many cases, almost dinosaurs.

I mean these benchmarks were created years and years ago, and they are maybe reflective of an investor opportunity set. But in terms of the benchmark construction, in terms of the risks embedded in them, there's room for improvement, suffice it to say. I think, in the coming years, you'd probably see substantial developments and innovations in the fixed-income space, in particular.

Charest: Well, thank you very much for sharing your thoughts with us today. For Morningstar, I'm Christian Charest at the ETF Invest Conference in Chicago.

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