As a growing number of new ETFs straddle the line between active and passive, investors are faced with a dizzying array of increasingly complex choices. Here's the compass you need to navigate.
By Ben Johnson, CFA | 09-18-14 | 11:00 AM | Email Article

Return-oriented strategies look to improve returns relative to a standard benchmark. Value- and growth-based benchmarks are prime examples of return-oriented strategies. Other return-oriented strategies seek to isolate a specific source of return. Dividend-screened or weighted indexes, such as those followed by  iShares Select Dividend and  SPDR S&P Dividend ETF , are the chief examples of this type of return-oriented strategy.

Ben Johnson, CFA, is director of global exchange-traded fund research for Morningstar.

Meanwhile, risk-oriented strategies look to either reduce or increase the level of risk relative to a standard benchmark. Low-volatility and high-beta strategies are the most common examples of risk-oriented strategies.

Lastly, "other" encompasses a wide variety of strategies, ranging from nontraditional commodity benchmarks to multiasset indexes. This second cut allows investors to classify strategic beta instruments along very broad lines.

The Devil Is in the Details
The third and final cut involves classifying products with similar strategic objectives at a more granular level. Here we group products tracking dividend-screened or weighted, value, low/minimum volatility/variance, nontraditional commodity, and a variety of other benchmarks together. This is intended to facilitate more-precise comparisons between products with very similar underlying methodologies. Exhibit 2 outlines our strategic beta taxonomy in full detail.

A Look at the Numbers
Overlaying our taxonomy on the U.S. ETP market yields some interesting results. First, this universe has seen tremendous growth over the past decade. (See Exhibit 3.) The rate of growth has only accelerated in the past five years. At the end of 2013, Morningstar counted 342 strategic-beta ETPs in the United States. These products had collective assets under management of $291 billion, representing nearly 18% of total ETP assets. Assets grew 59% in 2013 alone; net new cash inflows accounted for more than 34 percentage points of that figure, and asset appreciation accounted for the remaining 25 percentage points. Also, this is a category that has been punching above its weight. While strategic beta ETPs accounted for 18% of total industry assets as of year-end 2013, they garnered 35% of total net cash inflows into all ETPs for the year.

Exhibit 4 shows the breakdown of strategic beta ETP assets and their share of flows for 2013 along the lines of the secondary strategy attributes outlined above. ETPs offering access to dividend-screened or weighted strategies are the largest class of strategic beta ETPs. It should come as little surprise in the context of what has been a yield-starved market environment that dividend strategies have grown to account for nearly one third of assets in this space.

It is also important to note that more than 45% of assets in strategic beta ETPs are tied to what we would deem to be the first generation of such benchmarks--those that tilt or otherwise seek to isolate stocks with value and growth characteristics.

There are also some notable up-and-comers in the space. Fundamentally weighted strategies have been gaining traction as many of the ETPs tracking them now have track records of three-plus years, a fact that has bolstered some investors' confidence in their merit. Low/minimum volatility/variance ETPs have also attracted substantial investor interest as investors that are still feeling the sting of the 2008 downdraft in global financial markets adopt these strategies as a way to smooth their stock returns a bit.

What's Next?
What comes next in the land of strategic beta is more complexity. The latest wave of new products hitting the market is of the multifactor variety, combining a range of factor tilts or exposures into one fund. During the writing of this article,  JPMorgan Chase filed with the SEC to launch a suite of ETFs tracking multifactor equity benchmarks. These products are peeking over the fence that stands at the border between active and passive--mimicking active strategies in a rules-based, transparent, tax-efficient, and low-cost manner.

This layering of complexity adds to the due-diligence burden for investors. Investors' due-diligence processes for these funds need to be every bit as rigorous as those they would undertake in scrutinizing active managers. Morningstar believes that its taxonomy is an important first step in the direction toward helping investors to better understand the strategic beta universe.


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