Strategic beta and ETFs

Alternative beta, smart beta, and strategic beta: While some of the language used to describe its essence may be relatively new, the idea behind these roughly synonymous terms has roots dating back decades.

What is strategic beta?

Part of a broader trend toward rules-based investing that can seek a premium (or more than one premium for multifactor approaches) over cap-weighted indexes, strategic beta has enjoyed growing attention in recent years.

Often, the methodologies behind strategic beta portfolios are designed to screen an investment universe for securities with certain specified characteristics that are believed to offer the opportunity for better returns, less (or sometimes more) risk, or some other desired attribute, such as income generation.

Investors have been drawn to strategic beta’s cost, style purity, tax efficiency, transparency, and potential trading advantages – particularly when embedded within an exchange-traded fund (ETF) – benefits that can complement other allocations within a portfolio.

However, not all methodologies are conceived, structured, or implemented equally. Just as any potential investment deserves diligent assessment, it’s important to examine the range of objectives, expected return drivers, and potential risks across the spectrum of strategic beta offerings in order to find the right fit for your asset allocation program.

The benefits of strategic beta include outperformance potential at a lower cost

Leveraging goals of both active and passive management, strategic beta may offer complementary portfolio exposure for investors seeking inexpensive, diversified equity approaches with market-beating potential. Traditional cap-weighted index-tracking funds have provided investors with expedient and low-cost access to broad market exposure for more than 40 years.

While their virtues are significant, these passive funds aren’t as intrinsically neutral as they might seem on the surface. By definition, market cap weighting, the methodology used by many traditional market indexes, places greater emphasis on shares of larger, more expensive companies, which can produce unintended risk concentrations at particularly inopportune times. These indexes inherently neglect the equity of smaller, potentially more promising firms in favour of larger-cap companies that have already experienced significant growth.

Moreover, as they are instruments designed to mimic the market rather than to beat it, investors in passive cap-weighted index-tracking funds forfeit the potential of realizing relative outperformance. Active management, on the other hand, does allow for outperformance potential, but it’s generally more costly to implement than passive exposure, and not all active managers have provided investors with benefits commensurate with the price. A related drawback, active manager relative returns can sometimes be explained by market factor exposures rather than by security selection, revealing a lack of pure alpha-generating capability.

Strategic beta ETFs may be able to achieve similar portfolio exposures less expensively. By attempting to sidestep the drawbacks of cap-weighted indexing and active management, strategic beta aspires to offer investors the best of both approaches – the potential for outperformance by emphasizing specific segments of the market, on the one hand, and the low cost and transparency of a rules-based indexing approach, on the other hand.

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Robert Wernic

Robert Wernic, 

Director of ETFs

Manulife Investment Management

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