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When Does It Make Sense to Use a Strategic Beta Fund?

Michael Rawson, CFA

Mike Rawson: Hi, I'm Mike Rawson with Morningstar. I'm here at the Morningstar ETF Conference. I'm joined by Tony Davidow. Tony is the alternative beta and asset-allocation strategist with Schwab Center for Financial Research.

Tony, thanks for joining me.

Tony Davidow: Thanks for having me, Mike.

Rawson: Tony, one of the biggest topics in the ETF industry today is this concept of smart beta. It's a term that Morningstar is calling strategic beta. When people talk about smart beta, what types of investments are they referring to?

Davidow: I applaud you guys because I think that in the industry there is a lot of noise around smart beta without a real understanding of how these strategies work--how they compare and contrast. And I think the way that we look at it is anything that is non-cap-weighted--whether it's something that reflects a value or growth intentional tilt built in, or strategies like equal weight, low volatility, or fundamental strategies.

And what we try to focus on is, although they're all broadly defined as alternative weighting or non-cap weighted, at the end of the day they are actually very different. And I liked your taxonomy, the way that you have described it, because I think it helps investors hopefully make better informed decisions.

Rawson: Tony, you mentioned this concept of non-cap weighted. What does that do for a portfolio? Let's say I take a group of stocks and I change their weighting where I'm not weighting them by their market capitalization, which is something a traditional index such as the S&P 500 would do. When I break that link between price and weight, what does it do to the portfolio? How should I expect that portfolio to behave?

Davidow: I think it's a great starting point because I think a lot of investors don't fully understand what they're buying when they buy a market-cap-weighted index. The largest companies have the largest weight. A lot of the returns are impacted by the performance of the biggest names in an underlying index. So, you're very much dependent on the largest capitalization stocks driving a lot of the excess return.

When you think of these other strategies--which are designed to break the link with price--what you find is, by breaking the link with price, you are actually providing a very different risk-return pattern over time and, based on research we've done, these fundamental index strategies in particular have generated fairly significant excess return across the variety of strategies.

Rawson: So, I think it can be intuitive for investors to understand that these strategies give you exposure to factors that have been associated with excess return in the past. We know value has worked, we know small size has worked historically. The hardest part, I think, is knowing how to use them in your portfolio, and you've done some work about how the investors' objectives can influence their decision about whether they should be using a traditional passive-investment product, a strategic-beta product, or a completely actively manage product. Can you talk about that work?

Davidow: Yes. And I think it's a great jumping off point because, for us, we do believe there is a role for active and passive strategies, and we do believe these next-generation fundamental strategies are evolutionary in nature and deserve a role in the portfolio. So, what we have done is we have come up with four key levers that investors can think about as they think about allocating across those strategies.

For those investors who are very concerned about loss, they may want overweight active management. And again, there's a lot of historical data showing that active managers have had a difficult time consistently outperforming. However, there are managers who can do a better job protecting. An active manager can take risk out of the portfolio when markets get difficult. So, we would argue an underappreciated value of active management is loss aversion, protecting losses.

If you're concerned about tracking error--in other words, being different than the benchmark--or you are primarily focused on costs, we would argue you might want to have a higher allocation to a market-cap strategy. By definition, they are going to give you a market experience, and they will be the lowest-cost solution in the marketplace.

However, for those investors who are really looking to get a better experience in the market and ideally they're trying to seek and identify alpha, fundamental strategies--based on the historical research we've done--generate excess return over time. So, we would argue loss aversion, tracking error, cost, and whether you're seeking alpha and beta are key factors to think about as you allocate across those strategies.

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Rawson: Great. You've mentioned that active managers have the ability to reduce risk in rough market environments--maybe hold some cash. Index funds or strategic-beta funds are always going to be fully invested. You also mentioned the concept that it's difficult for active managers to consistently outperform a market-cap-weighted index.

However, these new strategic-beta indexes have a cost advantage over the average active manager. So, there is potential that there could be outperformance versus the average active manager who is charging higher fees.

Davidow: In fact, we have done that analysis. So, we look at these fundamental index strategies, and we look at their performance not only relative to a market-cap portfolio but we have actually used Morningstar data and we've actually looked at them relative to an active universe. And what we see is pretty consistent outperformance; not in each and every market environment, but over longer intervals they actually do perform quite well.

And if you think about what a fundamental index strategy does--and I will use just one example of it because there are different ways of weighting--but if you screened and weighted securities based on sales, cash flow, and dividends plus buyback, that's in fact what an active manager attempts to do. If you could do it in a disciplined, systematic way--and, as you point out, at a lower cost point--you are actually going to provide a better experience to the client over the long run.

So, we would argue there is a role for both active and passive. We really are very high on these fundamental index strategies because we think they capture a lot of the best attributes of what traditional market-cap strategies offer and what active managers attempt to deliver.

Rawson: The other thing that we look at at Morningstar is whether an investment is a strategic part of their portfolio, a core portfolio building block--which could be bought and held indefinitely--or if it's something that should be more of a tactical position, maybe sometimes referred to as a satellite position or if it's going to be bought and sold depending on market conditions.

Obviously, strategic beta is a broad landscape and encompasses a lot of different types of stocks. But let's talk about fundamental index: Is that the type of strategy that would be a core portfolio building block?

Davidow: Absolutely. And we've gone so far as to suggest an allocation across fundamental market cap and active management. In fact, in the most efficient market, we'd recommend a 50% allocation to fundamental; we'd recommend a 30% allocation to a market-cap portfolio; and because we see very little persistent outperformance, a 20% allocation to active management--and again, primarily focusing on active managers with better downside protection.

The flip side of it is, if we look at the emerging market (one of the least efficient markets), there we'd have a 50% allocation to active management, a 30% allocation to fundamental, and a 20% allocation to market cap. So, we believe it's a core holding; we believe you should have some exposure to all three. The weighting is somewhat dependent on the market environment and somewhat dependent on the segment of the market you are focused on.

Rawson: You mentioned that the fundamental index could be a core holding. In your asset allocation, you are recommending it as a core holding. Could you name any smart-beta type of products that you would view as more tactical or shorter-term holdings or you would need a fundamental thesis in order to buy it in the first place?

Davidow: Yes. And I'll also just add that you guys have done a terrific job in defining what that landscape looks like. And again, we interchangeably use terms like strategic beta and smart beta, but they are very, very different. And a lot of our research began to focus on this: For the average consumer, how do they distinguish amongst the strategies? So, we were looking at how are fundamental strategies different from low-vol strategies, which are different from min variance and high beta.

So, we'd argue fundamental strategies, based on the long-term historical data that we've been looking at, represent a nice core. But you could argue, depending on the market environment, things like high beta or low vol--if you had conviction in a market environment--they might be good tactical calls.

Now, of course, a low-vol strategy is going to lag in an environment like 2013, where the market is running and there is a lot of momentum; but if you believe that the 2015-16 timeframe is going to be difficult, you might want to deploy a low-vol strategy. The flip side of it is if you think the best days are still ahead of us, high beta may be used tactically to exploit that opportunity.

Rawson: Tony, thanks for joining me.

Davidow: Thanks, Mike.

Rawson: For Morningstar, I'm Mike Rawson.