Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As strategic beta ETFs have proliferated in recent years, Morningstar's research team has been stepping up its scrutiny. Joining me to share some recent research on the topic of strategic beta ETFs is Ben Johnson, he is director of global ETF research for Morningstar, and Alex Bryan, he is director of passive strategies research for Morningstar in North America.
Ben and Alex, thank you so much for being here.
Ben Johnson: Thanks for having us.
Benz: What are some examples of strategic beta strategies that are commonly in use today among ETFs?
Ben Johnson: If you look across the full gamut, the strategic beta umbrella includes a lot of different types of strategies--equity income funds, dividend-screened or weighted funds that look to suss out either the highest-yielding half of the market or firms that have been growing or maintaining their dividends over a specified period. There are value-oriented strategies. There's a whole host of different strategies that roll up underneath this umbrella.
Benz: Ben, you recently did some research where you looked at the success rate of strategic beta ETFs relative to the capitalization-weighted ETF universe. Let's talk about how you approach that research.
Johnson: Our research methodology was similar to the one that we use in our Morningstar Active/Passive Barometer. We compared strategic beta ETFs that track indexes that do not weight their constituent stocks on the basis of their market capitalization to the performance of those strategic beta ETFs that do weight their components on the basis of market capitalization. We are comparing, for example, in the U.S. large-cap value category the performance of an ETF like the PowerShares FTSE RAFI US 1000 to the performance of a composite of funds like the Vanguard Value ETF, which are, in our definition, sort of strategic beta 1.0. They tilt toward value stocks, but they weight those stocks on the basis of their market capitalization and tend to be priced at a lower level relative to their non-cap-weighted peers.
Benz: Alex, in the context of this study and in some of the other research that the team does, how did you define success?
Alex Bryan: In this context, we define success in the same way that we did for the active/passive barometer that you might be familiar with. We compared the performance of every strategic beta fund in each category against a composite of all the cap-weighted index funds in each category. For example, we would be taking something like the PowerShares FTSE RAFI US 1000 ETF and compare it against a composite of performance of funds like the iShares Russell 1000 Value Index and other cap-weighted strategies like that. In order to be counted as a success, if you will, in this case, the fund had to both survive the entire sample period and it had to outperform that average cap-weighted fund in the category. So, it's a binary metric, but it's one that will tell us whether or not you would be better off in this fund or if you would have been better off choosing a cap-weighted ETF at random in the category.
Benz: Ben, let's talk about the research finding. What did you determine when you looked at strategic beta ETF performance so far?
Johnson: What we should be clear about upfront is that the further we go back in time, the smaller the sample size becomes. If we were to go back 10 years, as we did in this study and look forward through the end of March of 2017, if you look across, say, U.S. large-caps, what we had was in aggregate, a sample of just 25 funds that track non-cap-weighted benchmarks. Now, what we found in that particular strata of the Morningstar Style Box was that success rates were quite high, in excess of 80% across all U.S. large-cap strategic beta ETPs. But that came down quite dramatically as you move down into mid-caps and into small-caps.
While that's certainly interesting, what we saw is that subsequently over the trailing five-year period, the trailing three-, and the trailing one-year periods is that those success rates came down and came down quite dramatically virtually across the board across all categories that we saw. Part of that has to do with changes in market environment, part of that has to do with the proliferation of new strategic beta ETFs that we've seen. Our sample has grown quite dramatically over the course of the past five- and certainly, more recently, three- and one-year periods. Indeed, in 2015 and 2016 what we saw were record numbers of new launches of strategic beta ETFs across a variety of Morningstar categories.
The results will, I think, be much more meaningful, much more reliable as we continue to sort of replicate this study through time. What I would also expect to see is that as the sample grows larger, these results will look more akin to what we see in the active/passive barometer. Going back to my answer to your original question, these are for intents and purposes active strategies. It will be unsurprising to see that over longer periods of time many of them will have a hard time getting the better of a more mundane, more vanilla broad-based cap-weighted benchmark.
Benz: Coming back to your point though about the strategic beta ETFs looking better over the 10-year period, does that mean that the funds that were originally launched are better than this new group, or what's going on there?
Johnson: Well, it's difficult to say. I think there are a variety of factors at play there. What we found is that certainly they took more risk relative to the cap-weighted index funds. What we found, too, was that they had greater loadings on specific factors. Across the large-cap spectrum in particular, what you saw was greater loadings on the size factor. In layman's term that means they tended to hold more small-cap stocks relative to their cap-weighted index peers. They had greater loadings on the value factor, which means that they tended to overweight cheaper stocks relative to the cap-weighted peers. Not unsurprising that they were different than the benchmark in this context, and it just so happened that over this particular period they were rewarded for having been different from the benchmark from sort of coloring outside the lines of their particular position in the Morningstar Style Box.