4 Smart Questions to Ask About Strategic Beta

Does the popularity of strategic-beta exchange-traded funds reflect the "wisdom of crowds" or the "madness of crowds"?

Despite the popularity of strategic-beta ETFs (or perhaps because of it), Vanguard founder and fund industry legend John Bogle has this to say about strategic beta:

"Smart beta is stupid; there's no such thing. It's an idiotic phrase. Quoting Shakespeare, I guess: It's a tale told by an idiot, full of sound and fury, signifying nothing." (Segal 2015)

While such a strong degree of skepticism may be over the top, it reminds us that we should never take any investment product for granted. In particular, when it comes to a strategic-beta ETF, we need to carefully consider the following questions.

1. Do you accept the premise of the strategy in question? The ideas for the strategic-beta approaches grew out of two strands of ideas. One is the notion of factor investing, in which a portfolio is tilted toward exposure to one or more factors that historically have produced returns superior to those of the market over long periods of time.

For equity portfolios, these factors include value (cheap outperforms expensive), size (small outperforms large), momentum (recent relative winners outperform recent losers), liquidity, and volatility (low volatility outperforms high volatility).

The other strand is the idea of using nonmarket-value-weights, especially weights based on company fundamentals as introduced by Rob Arnott and his firm, Research Affiliates. (See Arnott, Hsu, and Moore 2005 in references below). Many strategic-beta approaches both tilt toward factors and use nonmarket-value-weighting schemes. (Morningstar's definition of strategic beta includes approaches that tilt toward factors, but use a market-value weighting. See our "A Global Guide to Strategic-Beta Exchange-Traded Products.")

There is a great deal of debate as to why tilting toward certain factors has produced superior performance; i.e., result in performance premiums over the market portfolio. Some adherents to the efficient-market hypothesis claim that a premium associated with a factor is compensation for taking some sort of risk. In the anti-EMH camp, there are behavioral theories in which factor premiums are the result of irrational investment behavior.

Regardless of the reason that factor tilting works (or at least has worked in the past), because all investors collectively make up the market, if there is a group of investors who are systematically outperforming the market, there must be investors who are underperforming the market. This principle was first annunciated by Nobel laureate William Sharpe (1991). Based on this principle, Arnott coined the term "willing loser" to describe those on the losing side. He said, "[i]f we depart from cap-weighted indexation, we do well to recognize that we can beat the market only if someone on the other side of our trades is a willing loser" (as quoted in Rostad 2013). Hence, the premise for any strategic-beta approach should include the identity of the willing losers.

2. Can you withstand periods of underperformance? Even the best strategy cannot beat the market portfolio at all times. There will always be periods of underperformance. Consider Research Affiliates' flagship strategy, the Research Affiliates Fundamental Index 1000. The RAFI 1000 has impressive backtest results, especially over the simulated period January 1980 through December 2005, when $1,000 invested in the RAFI 1000 would have grown to $41,517, while over the same period, the same amount of money in the parent index, the Russell 1000, would have grown to $24,296. (These figures do not take into account real-world considerations such as management fees and taxes.)

However, things did not work out so well for investors in funds that track the RAFI index in the aftermath of the global financial crisis. At this time, value strategies were underperforming the market, and the RAFI index was no exception. At that time, Arnott said:

"Fundamental index portfolios have a value tilt, and that's going to help you when value wins and hurt you when it loses. Has it lived up to people's expectations? No. A lot of folks heard what they wanted to hear--long-term value added--and assumed that meant all of the time. That's just not realistic." (The Wall Street Journal, April 6, 2009)

If at the end of December 2006, one year after its launch, you had invested $1,000 in the

This illustrates how a strategy that backtests well can end up being disappointing in real time, especially after costs. This is not to say that the strategy will not outperform in the future. It is that no matter how strong your conviction in a strategy, you need to be able to bear periods of underperformance.

3. Do you think that past performance is due to an intrinsic premium-generating process or growth in the popularity of the strategy? We are all familiar with the disclaimer about past performance that goes with just about any investment product; namely, "past performance is not necessarily indicative of future results." No kidding. But Arnott and some of his colleagues at Research Affiliates have gone one step further. They write:

"We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." (Arnott, Beck, Kalesnik, and West 2016)

In other words, if the past success of a strategic-beta product was due to investors driving up its price rather than because the strategy was harvesting a factor-based premium, at some point the price must come down. This is an application of Stein's Law:

"If something cannot go on forever, it will stop." (Stein 1998)

I do not know if Arnott is right; only time will tell. But he is raising an important point about strategic beta that should be considered before investing in ETFs that track these strategies.

4. Are the fees worth it? Cost is always an important factor in deciding which investor products to buy. For example, in Canada, investors can get exposure to the Canadian stock market for an expense ratio as little as 0.03%. But once you move from broad market exposure to strategic beta, the expense ratio jumps to between 0.32% to 0.59%, depending on the strategy and the index provider.

While these expense ratios are far lower than those on traditional active mutual funds, they are high relative to those of broad market-weighted indexes. Costs always matter, so they should always be taken into account when selecting investment products. For example, if you invest in an ETF that has an expense ratio of 0.03%, with a gross return of 5% over 10 years, a $1,000 investment would grow to $1,624. However, if the expense ratio were 0.59%, with the same gross return of 5%, the investment would grow to only $1,535.

So, an investment in any strategic-beta ETF is a bet that the strategy will outperform the market portfolio by at least the difference in the expense ratios of the ETF in question and that of a low-cost market-index ETF.

Important to Ask Given the proliferation of strategic-beta ETFs, it would be a mistake to discount them all in a single stroke. But it would equally be a mistake to accept all of them as good investments. Inevitably, some will succeed and some will fail.

By taking a deeper look into what is behind them, we may be able tell which ones will succeed or fail in the long run. In other words, we may be able to tell which ones are gaining popularity because of the "wisdom of crowds" and which ones are doing so because of the "madness of crowds."

References Arnott, Robert, Noah Beck, Vitali Kalesnik, and John West. 2016. "How Can 'Smart Beta' Go Horribly Wrong?" Fundamentals, February. Research Affiliates.

Arnott, Robert, Jason Hsu, and Philip Moore. 2005. "Fundamental Indexation." Financial Analysts Journal 61 (2) (March/April): P. 83–99.

Bioy, Hortense, Jackie Choy, Christopher Davis, Pedro Antonio Da Silva Faria, Ben Johnson, Kenneth Lamont, and Alexander Prineas. 2015. "A Global Guide to Strategic-Beta Exchange-Traded Products." Morningstar Manager Research, September.

Rostad, Knut A. 2013. The Man in the Arena: Vanguard Founder John C. Bogle and His Lifelong Battle to Serve Investors First. John Wiley & Sons.

Segal, J. 2015. "Active Managers Losing Ground Can Thank John Bogle." Institutional Investor, January 27.

Sharpe, William F. 1991. "The Arithmetic of Active Management." Financial Analysts Journal, January- February.

Stein, Herbert. 1998. What I Think: Essays

This article originally appeared in the April/May 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.