What do you know about smart beta?
I've recently been in Chicago attending the Morningstar ETF conference. Morningstar, as many investors know, is an independent provider of market and investment research, accessible to all through www.Morningstar.com.
When you think of an exchange-traded fund (ETF), you might think "S&P; 500 Index replicator" — a passive index fund with the added characteristic that it trades throughout the day like a stock.
Now consider ETFs that incorporate active management. As Ben Johnson of Morningstar says, these are the "offspring of active and passive parents." Johnson is Morningstar's director of manager research.
According to Morningstar: "The category represents a middle ground on the active-to-passive spectrum — deviating from the traditional strictly passive market portfolio, but doing so in a rules-based, transparent and relatively low-cost manner."
If you've heard the term "smart beta" — or as Morningstar prefers, "strategic beta" — that's what we're talking about. These are ETFs that "seek to enhance returns or minimize risk relative to a traditional market capitalization-weighted benchmark," such as the S&P; 500 Index.
Strategic beta ETFs were introduced in 2000. iShares Russell 1000 Growth (IWF) and iShares Russell 1000 Value (IWD) were the first two such ETFs. They are now the two largest.
Growth of strategic beta ETFs has exploded recently. New money is flowing into these products quickly. Thirty-one percent of net new cash flow into all ETPs (exchange-traded products, which include ETFs and exchange-traded notes) is represented by strategic beta ETPs. During the past three years, one out of four new product launches in the U.S. ETP space is a strategic beta product.
As of the end of June 2014, there were 374 ETPs listed in the U.S. representing $360 billion in assets and 19 percent of total assets in ETPs.
Up until today, there was little guidance for investors who wanted to better analyze these products.
That is no longer the case. At this ETF conference, Morningstar announced a new classification system for strategic beta ETPs. The new system allows one to evaluate the underlying strategies behind these funds in order to make more informed investment decisions. The system allows for more easy comparisons of one ETF to another, based on strategies. That's important as new products enter the marketplace and as investor interest in these products increases.
Quoting from Morningstar's release:
"[Our classification] system first identifies strategic beta products as the investment style, then by the strategic objective of the underlying benchmark, and then the strategic objective at a more granular level. Strategy and sub-strategy classifications include:
"Return-Oriented: Strategies that try to improve returns or isolate a specific source of return relative to a benchmark. The strategies include: Value, Growth, Momentum, Quality, Fundamentals, Dividend Screened/Weighted, Earnings Weighted, Revenue Weighted, Expected Returns, Shareholder Yield and Multi-Factor.
"Risk-Oriented: Strategies that try to increase or decrease the level of risk relative to a benchmark. The strategies include: Minimum Volatility/Variance, Low/High Beta, Risk Weighted, Risk Parity, Maximum Diversification and De-Correlation.
"Other: A wide variety of strategies, which are not return- or risk-oriented. The strategies include: Equal Weighted, Non-Traditional Commodity, Non-Traditional Fixed Income and Multi-Asset."
Morningstar also released a report that educates investors about these products — you need to get a copy while it is available online for free. You can download "A Global Guide to Strategic-Beta Exchange-Traded Products" at tinyurl.com/q9rzvbw. (If you are unable to download the report, email me at readers@juliejason.com, or call me at 203-322-1198.)
Two additional resources you can download for free are "Morningstar Indexes 2014/15" and the April/May 2014 issue of "Morningstar Magazine," which is devoted to strategic beta. You will find the first publication at tinyurl.com/mds4p2s. The second is at tinyurl.com/n3h5gag. If you want to access all Morningstar analyst research reports, you can do that with a premium membership. The cost is $23.95 per month or $199 per year. Go to Morningstar.com for more information.
Julie Jason, a personal money manager, welcomes questions and comments (readers@juliejason.com).