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Can You Replicate a Strategic Beta ETF at a Lower Cost?

Alex Bryan, CFA
Christine Benz

Christine Benz: Alex, I want to home in on some research that you recently did. You came at this from a slightly different angle. You looked at how unique strategic beta ETFs are. Or in other words, would it be possible for someone to go out and buy some cap-weighted indexes that could kind of simulate what you could get with a strategic beta ETF but do so at a lower cost. Let's talk about your research and how you approached it.

Alex Bryan: The starting point that we had was that framework that Ben was talking about where we are comparing each of the strategic beta funds against the cap-weighted funds in each category. And that's a good starting point. But as Ben mentioned, a lot of these strategic beta funds do have different style orientations even within the same style box.

A good example is the Guggenheim S&P 500 Equal Weight ETF. This is an ETF that basically owns all the stocks in the S&P 500 but it weights them equally. It still falls in the Morningstar large blend category, but it tends to overweight some of the smaller names in that index. It actually behaves a lot more like a mid-cap blend index. And so, this was the motivation behind trying to see if there was a better way to try to control for some of these stylistic differences because it really is hard--it doesn't seem like it's fair to give something like that credit for outperforming just because it's owning stocks which are smaller. I could do that myself by just buying the Vanguard Mid-Cap Index at a much lower cost than I could buy that Guggenheim fund.

The research that I did, I basically looked at each fund and I looked at its returns and I tried to see if you could replicate each fund's performance using a combination of market-cap-weighted style indexes. For example, in the U.S. market I looked at the CRSP U.S. Large Cap Value and Growth Index, Mid Cap Value Growth, Small Cap Value Growth and tried to see if you could create composite portfolio out of those indexes to replicate the performance. What I found is that in most cases you can actually capture most of the strategic beta funds' outperformance with a combination of cap-weighted funds to the extent that those funds did outperform. Not all funds did.

I think it's evidence that a lot of these funds that are out there, while they are being marketed as distinctive strategies that are doing something unique, it turns out that what they are really doing is, essentially just repackaging traditional style exposures that you can get on your own more cheaply with the market-cap-weighted value or growth index down the market-cap spectrum.

Benz: One thing you noted in the research, Alex, was that it might not be practical for someone to go out there and cobble together a bunch of capital-weighted index funds, and that's not really what you are suggesting here, right?

Bryan: That's right. When we did this research, the main point was to try to see whether or not these funds were doing anything that was fundamentally different from market-cap-weighted value and growth index funds. Because a lot of times these funds are marketed as though they are a better mousetrap and they are priced accordingly. Now, it can be difficult to, as a practical matter, figure out what the composition of this replicating portfolio would look like out of these cap-weighted strategies. That's not necessarily the intent of this research. But that being said, a lot of times funds do have systematic biases. The Guggenheim S&P 500 Equal Weight Fund will almost always overweight the smaller cap names in the S&P 500. There should be a limit for what you're willing to pay as an investor for these strategic beta strategies because they are just repackaging these traditional risk exposures. I think that's the key takeaway here. You should not be willing to pay several times what it would cost to replicate that exposure. But that doesn't necessarily mean you need to go out and try to cobble together these replicating portfolios that I talked about in my research.

Benz: Really valuable research on a fast-moving topic. Thanks to both of you for being here to discuss it with us today.

Ben Johnson: Thank you.

Bryan: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.