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By Ben Johnson, CFA | 06-03-2014 02:00 PM

How Strategic Beta Can Factor Into a Diversified Portfolio

Combining strategic-beta approaches with each other, or with traditional cap-weighted holdings, can offer diversification benefits, though these strategies require long-term commitments, says Russell's David Koenig.

Ben Johnson: Hi I'm Ben Johnson with Morningstar. Strategic beta has been a hot topic in the asset management industry over the course of the past year, and while the category has continued, to grow the need for education is growing commensurately with it. To that effect today I am happy to be joined by David Koenig. David is an investment strategist with Russell Indexes and has done a ton of terrific research aimed at helping investors define good from bad in the realm of strategic beta.

David, thanks for joining me.

David Koenig: Well thanks for having me Ben. It's pleasure to be here.

Johnson: As investors try to unpack strategic-beta, or so-called smart-beta approaches these various indexes and the different funds that track them, what are some of the things that they should be on lookout for as they try to separate the good from the bad from the ugly.

Koenig: That’s a great question. These strategies really have opened up many new opportunities for investors to tailor their portfolios for certain exposures or to temper certain risks within their portfolios. But it is very important to understand the nature of these strategies, how they are constructed, and what the expectations are for these various strategies.

It's important that investors understand the basis for these strategies first of all. Really the true test of strategic or smart beta is whether it's not just based on some historical back test for outperformance, but rather that it's based on solid economic or behavioral rationale and then a wide body of academic research that’s looked into these various strategies for many decades such as research into the value factor or quality factor or momentum strategies. These types of strategies have been the subject of this academic research for a long period of time and have this underlying support that makes them valid strategies that can be incorporated into investor portfolios.

Johnson: A lot of that academic research has shown that some of these factors or these styles have indeed tended to outperform over long stretches of time. But these stretches of time I think in many instances are far in excess of your average investor's sort of own time horizon. How do investors appropriately manage their expectations when they look to implement a value strategy or a momentum strategy or a quality strategy within their portfolio? How should they be thinking about that performance over time?

Koenig: That’s a great point, as well. It is again very important to understand what the behavior of these various strategies is over time and that they can go through extended periods of both outperformance and underperformance. So with any of these smart-beta factor-based strategies, they do represent significant tilts toward a specific factor, and while over a long period of time a factor, such as low volatility or value, may show significant outperformance, there can be extended periods of underperformance, as well.

Investors need to understand that, be prepared for it, be committed to these strategies over the long term, and understand that there may be periods of underperformance along the way. Additionally, by combining several of these strategies within a portfolio, they can help to offset some of the periods of outperformance or underperformance and provide a smoother return pattern over time if you will.

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