Why Strategic Beta Is Here to Stay

What's New Two Ph.D.s at BlackRock, Ronald Kahn and Michael Lemmon, have published an article that predicts continued success for strategic-beta funds (to use Morningstar's marketing-shorn phrase for what the authors call "smart beta"--that is, the approach of investing mechanically but selectively, by using a system that buys only securities that have certain features (i.e. factor exposures, or betas). Examples would be a fund that buys only low-volatility issues, or one that holds stocks that have low price ratios and high recent price momentum.

That BlackRock, a purveyor of strategic-beta funds, forecasts health and happiness for strategic beta comes as no surprise. It could hardly be otherwise. However, despite the authors' self-interest, their outlook is correct. There are valid reasons why strategic beta has commanded headlines during the past few years--and has accumulated more than $300 billion in assets.

The authors find it significant that strategic-beta funds were created not by market demand, but instead by providers who anticipated the market's needs. Such "disruptive innovations," to use their term, are "motivated by a vision of how clients ought to invest--even when they do not realize a change is needed." As with personal computers and index investing, strategic-beta funds gave customers what they did not request, and did not believe that they needed.

That particular argument left me unconvinced. True, few investors had sought index or smart-beta funds before they were launched, but such has been the case for many of the fund industry's failures as well. Who craved a 130/30 fund? Or a short-term multimarket income fund (a tragedy from 25 years ago; don't ask)? Certainly, customer requests did not create "American Government" bond funds that held Argentine and Mexican debt (in the Americas and governments, get it?). The only disruption that those "innovations" accomplished was to lighten their investors' wallets.

Less Cost, More Predictability However, while I resist the authors' desire to graft strategic beta onto existing innovation theory, I can't quarrel with their thoughts when they return home, to the money-management industry that they occupy and know very well. As they point out, strategic-beta funds bring investors a genuine benefit. Before such funds were invented, those who wished to hold something other than "the market"--that is, market-capitalization-weighted indexes--were forced to buy active management. That meant assuming two deficiencies: costs that were much higher than those of the index funds, and unpredictable relative performance.

Strategic-beta funds address both problems. At an average of 0.40% per year, their expense ratios are well below even the cheapest of their actively managed rivals (aside from Vanguard's, as Vanguard is the eternal exception to the rule). (That said, 40 basis points is too steep for any mechanical strategy that has scale; as the strategic-beta business matures, I would expect that figure to decline significantly.) And, critically, they do not deliver surprises. As with traditional index funds, strategic-beta funds behave as their owners expect. If their factors perform well, so do they. If not, they do not.

Thanks to their relative predictability, strategic-beta funds are generally able to avoid blame when they lose money. It is the market, or the factors, that have performed badly, not the fund's management. That gives strategic-beta funds a significant reputational advantage over active funds. In the authors' words:

Strategic beta changes "the division of responsibility between investor and manager. An investor can fire an active manager who underperforms the cap-weighted benchmark over time. The investor is responsible for hiring the manager, and the manager is responsible for outperforming the benchmark. But an investor should not fire a smart-beta manager who delivers the promised exposures if those exposures lead to underperformance. The investor, not the manager, is responsible for the choice of those exposures."

That assessment is slightly off. While logically the investor should not fire the strategic-beta manager if that strategy hits a rough patch, as the fund has merely implemented the investor's own wishes, in reality the investor is quite likely to bail. As flows into, and out of, commodity exchange-traded funds illustrate, investors are undeterred by logic when chasing good results or fleeing bad ones. But critically--and to the authors' main point, which is very much on target--those who leave a losing strategic-beta fund are unlikely to harbor ill feelings. They likely will feel that the factor failed them, not the company that sponsored the fund.

Beta Easy, Alpha Not The authors ask, "How do we know that smart beta will not go the way of 130/30 strategies or portable alpha [once again, don't ask] or other occasionally popular innovations in investing?" They answer their rhetorical question by stating that strategic-beta investing, unlike those other inventions, "is about cost and packaging, not about doing something investors have never done before."

Spot on, although I think not fully in the manner that the authors intended. Their argument seems to be that strategic-beta funds deliver a conventional investment in a better way, while those other fund inventions offer a genuinely new type of investment. That is true as far as it goes, but I think that it misses the central point. Which is that those other recent fund launches need alpha. Not just portable alpha and 130/30 funds, but also market-neutral, long-short equity, and unconstrained bonds. Those funds are not attractive if structured as indexes. They only are worth owning if the manager succeeds with security selection.

And how often does that occur, for a category of funds as a whole, after fund expenses are paid? Not very often. Such funds were created on the implicit overpromise that their managers could accomplish what other funds' managers could not. No surprise, then, that those categories have disappointed their investors and are struggling to retain their assets. They were built to deliver what they cannot. Strategic-beta funds, on the other hand, can achieve what they say.

As last week's column showed, it's hard to avoid the lure of attempting to "beat the market." Even true believers in market efficiency are prone to the urge. Strategic-beta funds permit the indulgence of such temptations, in a fashion that did not exist before their creation. Will most of these betas succeed? Will they truly be smart? That I do not know; I will not predict the invention's investment success. But I do believe in their marketing fortunes. Strategic-beta funds have only begun their growth.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.