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Morningstar Launches Smart Beta Ratings System

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The fastest growing portion of the overall U.S. exchange-traded product marketplace is the strategic, or “smart,” beta segment of the market. And not only is this segment growing at a rate that is now outpacing growth in the broader ETP market place, but these strategic beta products are also growing increasingly complex.

In an effort to help investors better identify, compare, and analyze the more than 370 strategic beta ETPs in the U.S. as of June 2014, Morningstar introduced the industry’s first strategic beta exchange-traded product classification system at its fifth annual ETF Conference.

Ben Johnson, Morningstar’s director of manager research for passive strategies, elaborated on Morningstar’s definition of strategic beta and the taxonomy behind its strategic beta classification system during a preconference workshop.

“Having defined this space, we’re now able to measure it, to make sense of it, to analyze the trends that we see in this space and to help investors make sense of this space,” he told conference attendees. “Because, again, what we see … is new products in this arena are becoming increasingly complex.”

Strategic beta ETPs now make up roughly a quarter of the total ETPs in the U.S. and represent nearly a fifth of total assets in U.S. ETPs, at nearly $360 billion invested in strategic beta products. Johnson also said that an aveage of 25% of all new ETP launches over the past three years have fallen into this strategic beta category, while 31% of net new cash flows into U.S. ETPs went into strategic beta products in 2013.

Morningstar Direct, Morningstar Office and Morningstar Advisor Workstation, the company’s investment platforms for institutional investors and advisors, now include the new classification system and related data points.

“These will not override Morningstar categories,” Johnson said, adding, “This is complementary to our existing category system. It is not a substitute for our category system.”

Under Morningstar’s new strategic beta classification system, clients will be able to identify, screen and search for ETPs at three strategy attribute levels. The system will first identify 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.

Morningstar describes the strategy and sub-strategy classifications as the following:

  • 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 Decorrelation.
  • Other: A wide variety of strategies that are not return- or risk-oriented. The strategies include: Equal Weighted, Nontraditional Commodity, Nontraditional Fixed Income, and Multi-Asset.

What is widely referred to as smart beta, as Johnson explained, Morningstar chooses to call “strategic” beta. The first thing the research team did, he said, was “kick ‘smart’ to the curb.”

“We don’t think it’s warranted in every case,” he added. “Even if it is a smart strategy, it’s not always going to look smart.”

Morningstar defines strategic beta as a class of investment products that track indexes that seek to either improve performance or alter the level of risk relative to a standard benchmark, representing a fast-growing middle ground of the active-to-passive spectrum.

“Many have defined the space in the negative, saying essentially anything that is not strictly market capitalization-weighted is strategic, or smart, beta,” Johnson said. “Per our own definition, we have a much broader definition.”

Johnson added that their definition of strategic beta does include some indexes that underlie products in this category that are market capitalization-weighted, for example those with “style tilts.” Morningstar excludes cap-weighted sector benchmarks, thematic indexes like global clean energy, cap-weighted country benchmarks, or other type of indexes that screen constituents on the basis of sector membership, investment theme or geography.

Check out Rob Arnott Blasts ‘Smart Beta’ Imitators on ThinkAdvisor.