Christine Benz: Hi, I'm Christine Benz from Morningstar. After growing rapidly over the past decade, the universe of strategic-beta funds is maturing. Joining me to discuss that topic is Ben Johnson. He's Morningstar's global director of ETF research. Ben, thank you so much for being here.
Ben Johnson: Thanks for having me, Christine.
Benz: Ben, you put out a landscape report recently, where you looked at the state of the strategic-beta universe. Before we get into that, let's talk about the definition of strategic beta, just to make sure that everyone's following along here.
Johnson: Strategic beta, which many often refer to as "smart beta," is really a hybrid of active and passive approaches to portfolio construction. It tries to marry the best of both worlds. So the active parent of this hybrid beast introduces a bet against just owning the market outright. So that bet, oftentimes, is underpinned by a known factor, something that, over longer periods of time, across different markets, has proven that it can generate some degree of outperformance. So that could be value, buying cheaper stocks. Could be momentum, buying stocks that have been outperforming the broader market as of late, performing quite well. And strategic beta attempts to marry that active bet, or those active bets, with the best of passive approaches to portfolio construction.
So these funds track indexes. They're rules-based, so investors know full well what the rules of the road will be, which enforces a bit of discipline that may or may not be present in a traditional active strategy. I think, more importantly, it introduces the benefits related to costs that are inherent in passive, or indexed, approaches to portfolio construction. So the fees tend to be markedly lower relative to actively managed portfolios. And for those strategic-beta indexes that are tracked by ETFs, the ETF wrapper lends an element of tax efficiency that investors wouldn't benefit from, traditionally, in an open-ended mutual fund that's held by an active manager. So again, strategic beta, smart beta, whatever you want to call it, is really an active approach to portfolio construction that tries to leverage some of the benefits of an indexed approach to portfolio construction, marrying the best of both worlds, or at least trying to.
Benz: That's a helpful definition. So let's talk about some of the key trends when you look at this space, some of the key trends that you're observing.
Johnson: Well, it's a space that, if you look back over a longer period of time, has seen absolutely explosive growth. Many of the products that are available on the menu today were launched over the course of the past 10 years or so. Really, strategic beta kind of came into its own in the years following the global financial crisis. If you look at the US menu of strategic-beta ETFs, nearly three quarters of them were launched since 2010. Now it's a space that, more recently, has begun to mature. The menu has been saturated. We've seen new product launches slow. We've seen closures actually eclipse launches for the first time in 2019. So we've seen, actually, an attrition on the menu. We've seen flows taper, so market share gains have slowed as well.
And what we've seen more recently is, flows have all but petered out. So I think the menu has been saturated. I think investors, in many cases, have been overwhelmed by the amount of choice. And at the margin what you've seen is, those market-share gains have slowed because people are tending and, really, continuing to prefer more plain-vanilla, broad-based, market-cap-weighted index funds that tend to be incrementally cheaper still than many of these strategic-beta ETFs.
Benz: That's a good overview of the developments there. Let's talk about some recent developments, notable developments, perhaps in relation to what we're living through now, in 2020, with the strategic-beta universe.
Johnson: Yeah. If you think about the fact that three quarters of these funds were launched after the global financial crisis, what we saw earlier this year was really the first true test for many of these newer products. And they didn't necessarily pass with flying colors. So if you look at the success rates of strategic-beta ETFs across various Morningstar Categories, across various strategic-beta groups, they look a lot like what we saw from active managers during that period. Again, because these are, for all intents and purposes, active portfolios. It's an active approach to portfolio construction.
In some instances, we saw certain strategies that are positioned to take the sting out of market downdrafts--most notably, low-volatility ETFs yield mixed results relative to the broader market. Certainly, some witnessed relatively less volatility during the sell-off we saw earlier this year. Some, actually, incrementally more, as measured by greater relative drawdowns versus the broad market. And what we've seen subsequently is flows have slowed to a trickle. Flows into low-volatility ETFs in particular, which have been investor darlings now for a number of years, and powered much of the recent growth in the category, have actually turned negative for the year to date in 2020. So we've seen nearly $5 billion of investors' savings removed from low-volatility ETFs through the first six months of this year, which is a pretty dramatic turnaround relative to the trend that had been in place over the course of the past two or three years.
Benz: What should investors keep in mind if they are looking at this universe and potentially vetting some specific strategic-beta funds?
Johnson: Investors need to do their homework. They need to really sharpen their pencils and do every bit as much of due diligence when vetting these strategies, vetting their processes, which really are defined by their index methodologies, as they would when kicking the tires and peeking under the hood of a traditional discretionary active portfolio. Even like-labeled funds--so funds, for example, that fall under the dividend strategic-beta group--can yield wildly different results, especially over shorter periods of time. An example being, through the first six months of this year, the spread between the best- and the worst-performing US large-cap strategic-beta ETFs in the dividend group was nearly 30 percentage points. So it's incumbent upon investors, as always, to peel back the label on the tin, understand what the contents are, understand that index methodology, to ultimately understand how that portfolio will perform through different market environments--again, no different than they would an active strategy. Just because these funds are nominally index funds doesn't mean that their performance is going to look anything like a traditional, broad-based, market-cap-weighted index.
Benz: Okay, Ben. Good advice. Helpful insights as always. Thank you so much for being here.
Johnson: Thanks for having me, Christine.