Why Strategic Beta Makes Sense

This Time Is Different Thanks for bearing with me this far.

As I have learned from bitter experience, the topic of strategic beta--or “smart beta,” as fund marketers would have it--is not exactly a crowd-pleaser. Today’s article would generate much more interest were the subject Vanguard, or 401(k) plans, or how to make one’s money last while in retirement. Compared with those evergreen themes, the latest investment innovation seems trivial.

The masses have sound instincts: Investment innovations rarely deserve attention. Typically, they combine higher fees with swollen promises. Consider tactical asset-allocation funds. They package typically steeper expenses with the necessity that fund management succeed at market forecasting. Great. Or, 130/30 funds. They expect managers who can’t beat their cost hurdles while running long-only portfolios to do so after adding short positions, once again usually against a higher cost hurdle. Not likely. Then there’s portable alpha ... ah, never mind. You get the point.

But this time, I promise, is different. Truly.

(I made a somewhat similar argument two months ago, in an article titled “Why Strategic Beta Is Here to Stay.” I’ve learned a few things since then, however. This column covers some of the same territory but does so more concisely by shedding some marginal content and focusing on the key issues.)

If You Don't Ask for Much, You Might Not Be Disappointed The reason being that strategic beta, unlike most innovations, demands less from portfolio managers, not more. As a result, it charges less. There aren't many investment principles sounder than the statement that expecting less and paying less yields better results than expecting more and paying more.

To back up: Strategic beta means investing in indexed portfolios--but not the usual variety of index that copies an entire market. Strategic-beta funds own

part

of a marketplace, those securities that are exposed to a particular factor (or factors). Which all sounds ... abstract. But the concept is actually quite simple. A value-style index fund is a strategic-beta fund that uses the single factor of value.

All right, you say, I think I understand the concept--but that all sounds unnecessarily complicated. Why not just own the entire market? Why slice and dice, at additional cost and complexity? How do such machinations square with your assertion that strategic beta is a cost-saving simplification?

A fine question, Mr. Bogle. Strategic beta is indeed messier than conventional indexing. Those who wish to capture a financial market’s gains in the cheapest, most-logical, and most-straightforward fashion should not hold strategic-beta funds. In choosing to hold only a market segment rather than the whole, strategic-beta funds make active decisions. And active decisions, by definition, lead to higher expenses and more potential headaches.

Watch Out, Active Management! But--and now arrives the punch line--for those who wish to invest actively, strategic beta is the simplest of paths. Remember, previous investment innovations took traditional active management and then made more of it. More elaboration, more cost, and often (as with hedge funds) more opacity. Strategic beta takes the opposite direction.

Effectively, strategic beta argues, “Silence the noise, and you’ll see that most winning active managers succeed for only a few reasons--factors, if you will. So why not buy those factors and skip the rest?”

For example, a manager might seek relatively illiquid, low-cost stocks that have performed strongly over the past several months. The manager conducts much additional research and owns only a small percentage of stocks that pass his initial screens. But, it turns out, all that extra work matters not. The fund’s performance can be replicated closely by a mechanical model that sorts for: 1) low liquidity; 2) cheap stock-price multiples; and 3) high stock-price momentum.

That fund, in short, can be replaced by a strategic-beta competitor. Which, I believe, it will. Today’s investors recognize the importance of cost as never before, and they are equally aware of the struggles of active management. (As always, I write of active management’s aggregate results; there are always happy exceptions to the general rule.) Some will opt for fully passive portfolios. Most, however, will retain some thrill of the chase by blending passive with active. And that active portion might well take the form of strategic beta, particularly as investing actively through strategic-beta funds reduces surprises and eases information-gathering. As most strategic-beta funds are exchange-traded funds, their portfolio holdings are continually available, as opposed to quarterly for traditional active funds. (Never mind hedge funds.) Their trades are also more predictable. Portfolio managers can change their approaches at any time; algorithms, not so much.

Nothing's Perfect There are two catches.

The first being the lure of strategic-beta funds’ “track records.” Active portfolio managers aren’t permitted to advertise how their funds performed before they existed. Strategic-beta providers can, and do. Inevitably, their methodologies would have led to great performance in the past, had such funds actually existed. Well, yes. The investment approaches, after all, were created with such knowledge in mind; had the algorithms’ results been less than sterling, then their calculations would have been changed.

Which, in fact, is what occurred during the creation of most, if not all, strategic-beta funds. Relative failure, a fix, less failure, another fix, and so forth, until the final product was deemed acceptable. That is data mining--and its effects are the scourge of the sciences, particularly in medical studies, which has recently learned that many “proven findings” were false alarms. The same will prove true of many strategic-beta back-tests.

The other drawback to strategic-beta funds comes from their virtue of transparency. Easy to understand means easy to copy. Just as the first wave of strategic-beta funds will nibble on active management’s lunch, so will the second wave consume some of the first wave’s meal. The most-successful factors will breed copycat funds, which will attract more assets into those factors, which will boost the shares of the securities that are exposed to those factors, until the point that the factor premium has been priced away. At that time, the strategic-beta funds that had been the biggest past winners will likely be the future’s biggest losers.

In short, strategic-beta funds have the potential to be badly misused. I do not believe that such funds own enough assets to make that danger yet real--although Rob Arnott might disagree--but at some point, they will. Strategic-beta funds are well-designed, but that does not mean that they will be well-used. But that is a subject for another day.

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.