What Morningstar is deeming strategic beta is a broad and rapidly growing category of benchmarks and the investment products that track them. The common thread among them is that they seek to either improve their return profile or alter their risk profile relative to more-traditional market benchmarks. In the case of equity products, which account for the overwhelming majority of assets in this arena, the result is typically one or more factor tilts relative to standard market indexes.
As new products have continued to roll off asset managers' assembly lines, their sales and marketing departments have been working tirelessly to position these new models within an increasingly competitive field. The result has been a ratcheting up of the level of complexity of the indexes that form the raw stuff of these benchmark-based investment products and, in some cases, a growing disparity between how they are pitched by their sponsors and the actual investment results they produce. Investors are faced with a complex task as they navigate this landscape, and Morningstar is working to provide the compass they need to do so.
A Brief Historical Detour
The proverb "There is nothing new under the sun" applies to this "new" corner of the asset-management arena. Academics distilled investment returns into their component factors decades ago. And others, most notably the eponymous founder of Barr Rosenberg Associates, had recombined these basic drivers of investment returns into investable products. In fact, Rosenberg's "bionic betas" landed him on the cover of the May 1978 issue of Institutional Investor
So why is this time different? First, there have been major advances in information and investment technology since the mid-1970s that have given asset managers the horsepower necessary to efficiently manage more-complex index strategies, to repackage them into the newest generation of strategy-delivery vessels (such as ETPs), and to deliver them at a low cost to investors. The past four decades have also been marked by steady secular growth in index investing. Since the first index fund was launched in 1975, the portion of U.S. mutual fund and ETP assets accounted for by index-tracking products has grown from nothing to nearly 30% today. All told, the investment world of today is far more ready for these sorts of strategies than it was 40 years ago, when some people, as John Bogle has reported, were calling the concept of indexing "un-American."
What's in a Name?
The need to define this space, to measure it, and to police it has grown and will continue to grow with time. At Morningstar, we are positioning ourselves to meet these needs, all with the goal of helping investors make better-informed investment decisions. For our part, we have decided to tag this realm with the label strategic beta. Why strategic beta? First and foremost, we are eager to do away with the positive connotations that may be inferred by the "smart" in smart beta. Not all of the strategies included in this arena are smart, per se. The term strategic is meant to draw attention to the fact that the benchmark indexes underlying the ETPs, mutual funds, and other investment products in this space are designed with a strategic objective in mind. These objectives primarily include attempting to improve performance relative to a traditional market-capitalization-weighted index or altering the level of risk relative to a standard benchmark.
As for the beta in the name, it is not meant to imply beta in the strictest, most academic sense of the term (a measure of a security or portfolio's sensitivity to movements in the broader market). Instead, it is to highlight the fact that this is a group of index-linked investments, all of which have the goal of achieving a beta equal to 1 as measured against their benchmark indexes. Strategic beta may not roll off the tongue as easily as smart beta, but we believe it is a more accurate descriptor--one that doesn't imply that this universe is the index world's equivalent of Lake Woebegon.
It should be noted that these are merely attribute tags and not new fund categories, just as we do not have a "passive" or an "active" category. The portfolios of strategic beta funds exhibit a variety of investment styles. Our purpose in creating these descriptions is to help investors rigorously analyze this breed of funds, facilitating comparisons between those with similar strategies as well as within the context of their traditional Morningstar category.
A Motley Crew
In delineating the boundaries of the strategic beta space, we have tried to be as inclusive as possible, including products that may have a variety of different processes but yield fairly similar end products, and all of which deviate in some meaningful way from their traditional broad-based index peers.
Also, it is important to note that our definition differs from some others' in that we include products tied to benchmarks that first screen candidates for a variety of attributes (value, growth, and dividend characteristics, for example) and subsequently weight the eligible securities by their market capitalization ( Vanguard Dividend Appreciation
, for example). Others have adopted a more narrow definition that excludes any products based on benchmarks whose constituents are market-cap-weighted.
Our resulting universe includes a diverse range of products, spanning from the iShares MSCI All Country World Minimum Volatility ETF
to the YieldShares High Income ETF . The common elements among them:
Better Returns, Less Risk?
- They are index-based investments.
- They track nontraditional benchmarks that have an active element to their methodology, which typically aims to either improve returns or alter the index's risk profile relative to a standard benchmark.
- Many of their benchmarks have short track records and were designed for the sole purpose of serving as the basis of an investment product.
- Their expense ratios tend to be lower relative to actively managed funds.
- Their expense ratios are often substantially higher relative to products tracking "bulk beta" benchmarks like the S&P 500.
Having defined the strategic beta space in very broad terms, Morningstar makes a second cut of the universe, tagging products on the basis of the overarching strategic objective of their underlying benchmark. These objectives fall into three buckets: return-oriented strategies, risk-oriented strategies, and a catch-all "other" classification.