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Strategic Beta: What Investors Need to Know

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The last several years have seen a proliferation of strategic beta strategies. According to Morningstar Associates, assets under management in strategic beta strategies exceeded $400 billion in the third quarter, growing at a rate nearly double the industry average.

These strategies are designed to provide market exposure based on non-price-weighted fundamentals or economic factors. Popular strategic beta strategies include equal weighting, fundamental weighting, minimum variance, low volatility and other factor tilts. Often referred to as “smart beta” or “alternative beta,” they offer the potential for attractive risk-adjusted returns and can be used in conjunction with traditional market-cap and actively managed strategies to help create a diversified portfolio.

Gaining Exposure to Strategic Beta Strategies

Before investing in a strategic beta strategy, investors should understand the weighting methodologies, underlying indexes, sector allocations, market capitalizations and value-growth tilts it uses, and should keep in mind that portfolio characteristics will change over time. There’s a high degree of variability across the underlying indexes that these types of strategies track.

For example, fundamental strategies screen and weight companies based on economic factors such as sales, cash flow and dividends plus buybacks. These strategies are not “active,” but employ a rules-based discipline that removes the emotion that often hinders active management. Historically, fundamental strategies have delivered strong absolute and relative returns.

Strategic Beta IndexesTable 1 compares a few of the largest strategic beta indexes. As you can see, there are differences among the various strategies and their underlying weighting methodologies. As we will show, the differences in weighting methodologies can lead to divergence among the various strategic beta strategies.

Index Sector AnalysisTable 2 provides a sector analysis of five alternative weighting indexes and two market-cap indexes. These allocations differ because of their weighting methodologies. For example, look at the S&P Low Volatility Index, which has a 23.68% allocation to utilities and 20.84% to consumer staples. This is in stark contrast to the other strategic beta indexes, whose allocations to utilities range from 4.02% to 6.08%, while allocations to consumer staples range from 7.87% to 15.02%. The low volatility index likely has a greater emphasis on utilities and consumer staples because, historically, they have had less volatility than other sectors. The low volatility index also invests heavily in these two sectors relative to the S&P 500: utilities (23.68% versus 2.93%) and consumer staples (20.84% versus 9.76%). The difference in sector allocations may lead to dramatically different results over time—which could either help or hinder performance.

Other differences across these indexes, and relative to the broad market indexes (S&P 500 and Russell 1000), are byproducts of the weighting methodologies rather than intended bets on the markets. Investors should carefully consider the underlying portfolios and be mindful of the potential overweights and underweights versus the broad market indexes that may occur. These significant variations could lead to performance differences.

Asset Allocation by Market CapMarket capitalization is another important consideration when evaluating these strategies. For example, Table 3 shows that the S&P 500 Equal Weight Index has the highest allocation to mid-cap stocks and the lowest allocation to mega-cap stocks. Equal weight indexes provide the same weight to every company in an index. Equal weight strategies generally have a smaller capitalization overall than their market-cap equivalents due to larger companies receiving a smaller allocation and smaller companies receiving a larger allocation.

Table 3 also provides a breakdown of allocations across value, core and growth. The FTSE RAFI U.S. 1000 and the S&P 500 Low Volatility indexes have the highest allocations to value (49.48% and 47.17%, respectively), and the S&P 500 Equal Weight is the closest to a neutral weight between value and growth (31.80% versus 32.15%). The broad market indexes—S&P 500 and Russell 1000—are also close to neutral weighting across value, core and growth. While critics may state that strategic beta strategies are merely exploiting the value and small-cap effects, the data shows the magnitude of value and small cap varies a great deal from strategy to strategy.

Implementing Strategic Beta Strategies

Strategic beta strategies can complement both market-cap and actively managed options. Examining some of the characteristics of strategic beta, market-cap and actively managed solutions will help in determining the allocations to each type of strategy when it comes to portfolio construction. The Schwab Center for Financial Research has conducted research on fundamentally weighted index strategies, and has developed a unique point of view regarding incorporating them into portfolios.

Market cap provides little or no tracking error (fees could provide a small drag on performance), no downside protection potential and no alpha. Fundamental strategies have historically delivered alpha and have a relatively high tracking error compared with market cap. Active managers seek to deliver alpha and may provide a level of downside protection. Although there are merits to index-based strategies, such strategies are unable to deviate from their rules-based discipline. Active managers have greater flexibility and can adapt to changing market dynamics.

Table 4 shows the four key levers that can help determine weightings among these types of strategies: tracking error, loss aversion, alpha and cost. Depending on an investor’s sensitivity to the levers above, they could choose to overweight or underweight each of these types of strategies.

Four Levers of Strategic WeightingMarket cap. Investors who seek a cost-effective way of owning the market and want to limit tracking error may want to consider an overweight to market-cap strategies.

Fundamental. Investors who are seeking alpha and have little concern about tracking error may choose to overweight strategic beta strategies.

Active. Investors concerned about the ever-changing market environment and who want an active manager to be able to alter their strategy over time may want to consider a larger allocation to active management. Advisors should seek to identify managers that have historically delivered better relative performance in down markets, although a manager’s past performance is not a guarantee of future results.

Strategic or smart beta strategies are considered sophisticated ways of building index-based portfolios. These strategies provide different ways of accessing the various market segments and offer different return and risk characteristics. They apply logic and academic research to the weighting methodologies used in index construction, leading to a different client experience.

As strategic beta strategies have been embraced by institutions and individual investors, the number of alternative weighting strategies and the flows into them have increased dramatically. Before investing in a strategic beta strategy, investors should understand the differences between strategies, including how varying market conditions may affect their use within a given portfolio. In addition, certain strategies introduce biases through their weighting methodologies.

Investors should evaluate both a strategy’s weighting methodology and the underlying index used, which may vary the security, sector and market-cap exposures and could lead to dramatically different risks and returns over time. Caveat emptor: Not all strategic beta strategies are created equally.

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