Making the Case for Strategic Beta as Fees Plunge

Morningstar's Ben Johnson and Schwab's Tony Davidow offer their analysis and advice

(Photo: Thinkstock) (Photo: Thinkstock)

Despite the growing variety of strategic beta funds, investors are preferring plain vanilla growth and value funds above all others, according to Ben Johnson, director of Global ETF Research.

Morningstar characterizes market-cap weighted growth and value index funds as strategic beta, unlike other firms who include only funds that take into account factors like size, value and volatility and are not cap-weighted; they usually refer to those funds as smart beta.

Morningstar’s data shows that strategic beta assets have grown 27% year over year through the end of September to $652 billion, driven by both new asset flows and market appreciation. The share of new flows dedicated to strategic beta, however, declined to 11.5% during the first nine months of this year compared with the same period a year ago, according to Morningstar.

(Related: Smart Beta Strategies More Popular Than Ever and Growing Rapidly: Survey)

“Strategic beta is a new form of active management” that costs less and has significantly more tax advantages than traditional funds because of the in-kind redemption mechanism, says Ben Johnson, director of Global ETF Reserch. (When ETF shares are redeemed, the ETF issuer doesn’t have to sell stock to pay the authorized participant, who has obtained the underlying assets needed to create the ETF. The ETF issuer can pay with the underlying holdings of the ETF, and thus avoid a taxable event.)

Moreover, strategic beta fund costs have been declining. Since late June, Guggenheim cut the fee for its equally weighted S&P 500 fund (RSP) from 40 basis points to 20, PowerShares introduced an S&P Minimum Variance ETF (SPMV) charging 13 basis points and Goldman Sachs underpriced them all with the launch of its equally weighted U.S. large cap equity ETF (GSEW) for a cost of just 9 basis points.

Johnson expects the decline in fees will continue.

The latest Schwab ETF investor study showed that three in 10 investors are using strategic beta funds, with millennials their most avid investors, and that two-thirds of investors reducing their shares of actively managed funds are reinvesting those funds in smart beta products.

The challenge for advisors and investors is choosing a particular smart beta fund or funds among their growing number and variety.

“Five years ago the discussions were focused on whether the strategies work,” says Tony Davidow, vice president, alternative beta and asset allocation strategist at the Schwab Center for Financial Research. “Now the discussions with RIAs and individual investor clients is on how to distinguish among the many options … and how they work.”

He suggests that advisors focus first on what problem they want to solve by investing in strategic beta products before choosing a particular strategy, such as equal weight or fundamentals (scale, cash flow, dividends) or something else.

Schwab favors a multi-pronged approach using active, smart beta and market-cap weighted index funds, with a defined role for each. Davidow is not too concerned about the overlap among them so long as each are using different strategies.

One strategic beta-type fund that has been gaining more currency recently is the multi-factor fund. These funds can appeal to investors who like the idea of the fund itself making allocation decisions among different strategies, says Johnson, adding that there isn’t much data yet about the performance of such funds.

Whether strategic beta funds fit in a portfolio will depend on the investor’s objective, says Johnson. “It may move the needle for some and not for others.” 

--- Check out Target-Date Managers Expect to Offer Strategic Beta on ThinkAdvisor.

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