The 5 principles of a good strategic beta approach
1) Low cost
An absence of stock-forecasting or macroeconomic predictions means a large investment team is not required. A straightforward approach should cost little more than passive indexing. More complex strategies may be priced at a premium but should still be cheaper than active management.
2) Sensible index construction
The factors selected must be well-considered. They should be either durable predictors of return, or if not durable, there must be scope to adjust factors over time in a transparent way. Alternatively, factors may not target outperformance but some quality of return that investors demand (for example, high income or low volatility).
3) Capable people
Those behind the strategy must have an understanding of financial theory, market reality, as well as expertise in trading/execution.
4) A wide investment universe
An advantage of strategic beta is the ability to use computers to process a wide array of information. For example, RealIndex can quickly compare the price/book and price/earnings ratios for every major stock in the emerging markets universe. If there is only a small universe, or the universe is skewed, active managers may be better equipped. The Australian market, dominated by a handful of banking and resource stocks, is vulnerable in that regard.
5) Good data
Strategic beta is only as good as the quality of the data. Accounting data (for example, sales and balance sheet figures) can vary greatly. Data must be consistent across countries and industries, or alternatively, it must be rigorously standardised.
A number of strategic-beta approaches have long track records of success and we agree there is some logic to constructing indices using factors beyond just market cap. After all, just because a company is big does not necessarily mean it's a good investment.
But investors must understand what they are buying and why. Strategic beta is not a panacea and inevitably these strategies will go through difficult periods. For example, income-biased strategies will suffer if high-dividend stocks underperform -- an easily imaginable scenario given their strong performance in recent years.
Value strategies may suffer when the economy is weak or when risk aversion spikes. But given strategic beta's relative transparency, investors should have little to complain about so long as they have done their homework.
The text for this article has been written by Ben Johnson, global director of manager research for passive strategies, Morningstar, and Alex Prineas, a Morningstar fund research analyst.
