Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Morningstar recently published its global guide to strategic-beta products. To provide an update on the state of this part of the market is Ben Johnson. Ben is Morningstar's director of global exchange-traded fund research.
Hi, Ben. Thanks for being here.
Ben Johnson: Hi, Susan. Thanks for having me.
Dziubinski: Let's start out with the definition. How do we define strategic-beta funds?
Johnson: I think the easiest way to define it is if we pick that term apart and look at its two constituent words. So, "strategic" or "strategy" implies that there is a strategy here. It's an investment strategy that in some way deviates from whatever its starting point might have been, which is often a broad-based market-cap-weighted index. So, say, a Total U.S. Stock Index, say an Aggregate Bond Index, something of that sort.
The "beta" implies that these, despite the fact that they move away from the beta that is that broad market index, are still index products. So, these are indexed funds that have indexes that in and of themselves are not trying to just measure the market and its performance at large but are trying to mimic certain investment strategies. The first generation of these very simply leaned in one direction or another. They leaned in the direction of value as a style, cutting the U.S. market in half and just focusing on the value half of the market or the growth half of the market. And what we've seen is that, over the ensuing decades, these strategies have evolved. And most recently, we've seen them pick apart individual factor exposures, so things like value and growth, momentum, and low volatility.
And then, we've seen them recombine to bring those factors together in multifactor portfolios. So, if you fast-forward from the early 2000s when those style-based index products were first making their way to the market to today in the ETF space, you've got increasingly complex multifactor exposures, things that try to time their factor exposures. The commonality among all of these things is that they are sort of a new version of active management that is codified in an index rulebook and implemented in a passive way. Once that rulebook has been set, the portfolio managers don't wake up every day and decide whether they want to own Coke or Procter & Gamble. They execute according to that playbook. And most of them, if not all of them, are trying to do better than the market, no different than an active manager.
Dziubinski: Now, strategic-beta products had been growing at a pretty good clip over the past several years. Growth slowed a little bit in 2020. Let's talk a little bit about that.
Johnson: If we look specifically at strategic-beta ETFs in the U.S., what we saw was that, going back to the early 2000s, they started with a market share of nothing and that subsequently expanded in recent years to account for nearly a fifth of all assets invested in U.S. ETFs. Now, in recent years, what we've seen is that those market share gains have stalled and in 2020 indeed what we saw was that those market share gains actually reversed. And this is something we've been documenting now for a number of years is that it's really an asset-management industry product cycle. It's a phenomenon that has really, as far as we can tell, reached full maturity. And that's not evidenced solely by the fact that market share gains have stalled and reversed, we also see other signs. Specifically, last year in the U.S. was the first year that there were more strategic-beta exchange-traded funds that were actually closed than new ones that were launched. So, the total number was actually reduced for the first time in decades looking back to 2020.
What we've also seen, which has been prevalent across the ETF and indexing complex in recent years is that there has been tremendous fee pressure. These are at the end of the day, albeit though they are differentiated indexed products, indexed products. You're not paying armies of very highly educated, very well-equipped portfolio managers and analysts to go out and scrutinize individual securities and select them and monitor portfolios. You're just trying to track a benchmark, no different than you would a broad-based benchmark like the CRSP Total Stock Market Index. So, it's been natural as part of the evolution of the maturation of this space that fees have come under pressure as well and flows have fizzled to a degree, too. So, market share gains have slowed. Closures now outnumber new launches. Fee pressure in really sort of a saturated space that in other corners of the market it's had the spotlight stolen from it as the asset management industry has moved on to the next product cycles. And I think you can see notable examples of those today in what we are seeing in terms of ESG, especially within the ETF sphere as well as within the realm of thematic funds.
Dziubinski: What are we seeing in terms of strategic-beta funds that continue to be somewhat popular today?
Johnson: Some of the most popular funds are those originals, those style-based benchmark products that either tilt toward value stocks or tilt toward growth stocks. One category that continues to be particularly popular in the U.S., though, we've seen its popularity mimicked and even grow in some other corners of the market outside the U.S. is in dividend-focused strategic-beta ETFs. So, if you think of funds like the Vanguard Dividend Appreciation ETF VIG, that's a fund that carries a Morningstar Analyst Rating of Silver; the Schwab US Dividend Equity ETF--SCHD is the ticker for that one--which carries a Morningstar Analyst Rating of Silver. These are two examples, prominent examples, of funds that fit into the Morningstar dividend strategic-beta group and funds that have done very well by investors over the years and have amassed a tremendous amount of assets as a result. And that's in no small part owing to the prevailing interest-rate environment. The fact that interest rates are depressingly low, if not negative, in real terms, and you've got this massive demographic shift underway where more and more investors are moving from the accumulation phase of their investment life cycle to spending down the assets that they have accumulated and they are in search for income. So, it's really no surprise that the popularity of dividend ETFs has really continued, and I expect it will only continue in the years to come.
Dziubinski: Now, low-volatility strategies had been somewhat popular as well, but that changed a little bit last year, right?
Johnson: They had been market darlings in recent years, absolutely, amassing tens of billions of dollars in new assets. And what we saw was that in 2020 that reversed quite sharply. And what I would argue is that there are probably two key reasons for that reversal. First and foremost, what we saw was that in the worst of the drawdown that we experienced in the first quarter of 2020, some of these funds simply didn't deliver the goods. There were some that actually fared much worse, had much steeper drawdowns than ETFs and index mutual funds that track their parent index. We knew all along that "low volatility" didn't mean "no volatility," but it would be fair to expect less volatility over a long enough time horizon. I think what some investors did not expect is that low volatility meant actually more volatility in a very acute drawdown like the one we experienced last year. I think part of this is performance-related, and it comes at the end of what had been a very good stretch of performance for many of these funds.
The other big factor, I think, is a factor rotation of sorts that's underway. And what we've seen in recent months is that the value factor and value funds in particular have had a bit of a comeback. Now, this might be a false spring for them. It might just simply be a junk rally. But what we've seen is that in response to this shift in factor leadership, there have been billions of dollars that had flowed out of low-volatility ETFs and into ETFs belonging to Morningstar's value strategic-beta group.
Dziubinski: At the end of the day, Ben, what do you think will continue to drive growth in strategic-beta products?
Johnson: I think because strategic beta for all intents and purposes is just another form of active management in many respects. Performances is ultimately what is going to attract investors' attention. And what you see is that if you look out at the landscape of the hundreds of ETFs that are out there today that fit into this bucket, many of them are still very young. They don't have very long track records. Some of their track records frankly have been disappointing. And what we've seen thus far is that investors really take a very similar approach to vetting and choosing strategic-beta funds as they would in vetting and choosing actively managed funds. And I would argue that that's a good thing, that they're rolling up their sleeves, they're doing their due diligence to the extent that they're benefiting from some of the key benefits of just index strategies more broadly in terms of low costs, and to the extent that these are ETFs that we're talking about relative tax efficiency, that's great. But nonetheless, certain strategic-beta ETFs by virtue of being different than the market, are going to do better than the market, and others will do worse. No different than discretionary active managers.
Dziubinski: Ben, thank you so much for your time today and your take on this specific part of the exchange-traded product market. We appreciate it.
Johnson: I appreciate you having me. Thanks, Susan.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.
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