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How Strategic Beta Can Factor Into a Diversified Portfolio

Ben Johnson, CFA

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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Johnson: When you talk about using these factors or these strategies in combination with one another to complement one another, what are some of the pairings that have tended to work best over time?

Koenig: That’s a great question. There has been a great deal of academic research into factors such as the value factor for instance, and the momentum factor; both of those factors have been shown to outperform over very long periods of time. But interestingly individually they tend to have very low correlation and even negative correlation in many instances or over time. So by combining a factor strategy based on value and a factor strategy based on momentum, for instance, you can create a very interesting type of dynamic between those two.

Additionally, there are other strategic-beta types of strategies, such as fundamental weighting for instance, that while it's not specifically focusing on a single factor, it does have distinct differences in terms of its exposure and behavior over time relative to a cap-weighted index, for instance. So by combining a cap-weighted strategy along with a fundamentally weighted strategy, investors can benefit from the diversification among those index-based strategies within the portfolio.

Johnson: David thank you for coming here to be with us today and shedding some light on what's an important and complex topic and helping us to, in turn, help investors to make sense of strategic beta.

Koenig: Well, thank you again Ben. I appreciate it.

Johnson: For Morningstar, I'm Ben Johnson.