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Sizing up strategic beta

Contributor Yazann Romahi

Interest in strategic beta ETFs is rising. A few simple guidelines can help investors pick from among the often-bewildering number of options.

The number of strategic beta ETFs has grown at 20% a year, consistently in good markets and bad, since the year 2000.1 With good reason: Strategic beta ETFs offer a more thoughtful passive option than cap-weighted indexes—and they can do so with a more transparent process and lower fees than actively managed funds.

Bright future, dim past

All well and good, but how should investors assess any particular strategic beta ETF? Close to 40% of these funds have been in operation for less than three years.1 This lack of an established track record can make it hard to validate their claims. ETF sponsors may try to make up for that shortcoming with back testing, running simulations of holdings they might have had against actual past market performance, but that has its limitations:

  • Back testing doesn’t always account for fees, liquidity or transaction costs.
  • Back tests are “selection biased”—that is, back testers have a tendency (conscious or not) to engineer positive outcomes. Live outcomes are therefore likely to be inferior.
  • Too great a focus on recent history can lead to “driving in the rearview mirror.” While an index or ETF may solve the problems of yesterday well, an investor’s focus should instead be on solving the potential problems of tomorrow.
Three steps to an informed judgment

Because the indexes tracked by strategic beta ETFs are by design somewhat exotic, effective assessment of them calls for some digging:

  • Investors first have to understand who the index designer and asset manager are (they may not be the same people). They should have a clearly expressed investment philosophy and the expertise to enact it in practice.
  • The properties of the portfolio should reflect the investment philosophy. Not only does the transparency of ETFs allows examination of the holdings to ensure that this is the case, it also measures such as active share relative to a cap-weighted benchmark or turnover can indicate whether an ETF is performing as designed.
  • Performance can also be used to confirm that an index is doing its job. While short-term results shouldn’t be given too much sway, the index designer should be able to explain when and why an index will perform and when it might not.

One key aspect of performance shared with traditional passive management is tracking error. Like earlier cap-weighted index tracking funds, strategic beta ETFs should have minimal tracking error to their own indexes. Beware, though, the tracking error to the benchmark can be large and dynamic, it is by this differentiation that strategic beta adds value.

Made to measure

Strategic beta does not defy analysis, despite its novelty. Indeed, it has a lasting advantage over standard active manager due diligence. Strategic beta, after all, is rules-based. What an investor sees in straightforward, well thought-out index composition rules is what the investor will get. In that sense, strategic beta is relatively immune to the personnel changes, style drift and index hugging that can challenge actively managed mutual funds.

To learn more about J.P. Morgan's pragmatic approach to assessing strategic beta strategies, read the full paper:

Strategic beta's due diligence dilemma  

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Strategic beta's due diligence dilemma
We teamed up with our MAS partners to provide guidance into key considerations when assessing your strategic beta investments
1Morningstar as of March 2016.