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Strategic Beta: Investment Fad or Opportunity?

Ben Johnson, CFA
Jeremy Glaser

Note: This video is part of Morningstar's April 2015 Active, Passive, and In-Between special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I am here today with Ben Johnson--he is our global director of ETF research--to take a look at the state of strategic beta exchange-traded products.

Ben, thanks for joining me.

Ben Johnson: Glad to be here, Jeremy.

Glaser: Let's start by just looking at the growth of these so-called strategic beta products over the last couple of years. What are these things and why have they become so popular?

Johnson: Strategic beta, or so-called "smart beta," represents a hybrid of active and passive. It sits in this middle ground between active and passive. Like active funds, strategic beta exchange-traded products and mutual funds track indexes that have an active bet embedded in them from the moment that their methodology is locked in. Now, like their passive parent, strategic beta benchmarks are transparent. They are investable in a rules-based manner, and they are investable at a very low cost. So, it's this combination of active and passive where we find strategic beta.

Glaser: And this has been gaining traction recently?

Johnson: Absolutely. So, if you look at the U.S. marketplace as it stands today, there is in excess of $400 billion invested collectively in exchange-traded products that we define as fitting into the strategic beta bucket. That figure has been growing at about a 20% compounded rate for a number of years now, and what we see is that it has accounted for a disproportionately large percentage of net new flows into exchange-traded products. We've seen a lot of product development in this space as well. It has grown to the point where, today, it accounts for about a fifth of the overall U.S. exchange-traded products pie.

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Glaser: What kind of investors should be looking at these kinds of products? How does it fit into a portfolio?

Johnson: Well, the fit really depends on the investor, and it depends on the use case. What we see is investors of all stripes are using these products in a variety of different ways. If we break it down and we look at it more granularly, at the different subcategories of what we've referred to in very broad terms as strategic beta, what we see is that, globally, the largest subsegment is equity-income-oriented [exchange-traded products]. These are exchange-traded products or exchange-traded funds that track some sort of dividend-focused index. And what that tells us is that, in a yield-starved environment, investors are using these broadly available, very transparent, very efficient, very low-cost tools to juice the yield in their equity portfolios. And that applies, in the U.S., chiefly to advisers and individuals.

Now, in other contexts, what we see is more-narrow, more-focused, targeted factor exposures that are being used for very precise, fine-tuning of risk exposures by very large institutions. So, a perfect case in point there is the Arizona State Retirement System. They worked in conjunction with BlackRock iShares and MSCI to develop a targeted suite of factor-specific tools--ETFs that are designed to capitalize on momentum and designed to capitalize on quality for their use--and, again, very finely tuning the risk exposures of their overall portfolio. So, it's a whole spectrum of investors that are using these implements for a whole variety of different uses.

Glaser: So, this is obviously a broad set of investments; but when you look at the space, what are some of the funds that you think are worthy of a place in your portfolio and maybe some ideas that aren't quite fully baked yet?

Johnson: So, I think two of the funds that we really like, that we think are most suitable for a long-term core-equity holding covering U.S. stocks would be the PowerShares FTSE RAFI 1000 ETF (PRF). What that embeds is a unique discipline whereby this underlying benchmark regularly and very sharply rebalances toward value and weights based on the fundamental value of the underlying securities. So, what you've seen over time is that that methodology has fared very well, particularly coming out of downdrafts in the market. It rebalances into pain and discomfort. It sort of feasts when there's blood in the streets, and it's available at a low cost.

The other one, which is more of an equity-oriented income strategy, would be the Schwab US Dividend Equity ETF (SCHD). This is a very low-cost way to get exposure to a very high-quality portfolio of dividend-paying blue-chip U.S. equities. Those are two of our favorites in the context of a core long-term U.S. stock holding.

Glaser: So, certainly, there are some strategic beta funds that sound like they do have a good role in people's portfolios, but there probably are also other ones that maybe you should be a little bit more skeptical of?

Johnson: Absolutely. And I think investors at large should approach this category with a healthy degree of skepticism, just as they should with any investment that they are looking to make, particularly because this is a space that's been very long on marketing hype and not always equally long on real investment merit, real substance. So, there's a whole host of more esoteric, very high-priced, high-cost funds that are coming out that, again, I think are longer on marketing than they are on investment merit. It's important that investors, I think, first and foremost, look at the costs, because what you're seeing is that there's this emphasis on "innovation" and "differentiation" that's being done, in many cases, at investors' expense. It's used as a justification for relatively higher fees. So, it's incumbent upon investors to approach this with a keen eye on costs and make sure that they're not paying active-management prices for passively managed products.

Glaser: Ben, thanks for your take on the strategic beta landscape today.

Johnson: Glad to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.