Navigating The Strategic Beta Explosion

What all those smart-beta ETF names actually mean for your portfolio.

Director of Research
Reviewed by: Elisabeth Kashner
Edited by: Elisabeth Kashner

Indexes have evolved over the past two decades, with newer versions offering strategies such as a dividend focus, fundamental emphasis or factor exposure. The rise of these "strategic beta" indexes has allowed ETF issuers and index providers to attract the interest (and fees) of investors who distrust active management, but believe in the promise of a differentiated investment strategy.

With $424 billion in AUM as of Dec. 31, 2014 generating nearly $2.2 billion/year in management fees, strategic-beta funds have changed the ETF landscape. These funds offer choices (and complexity) for investors, increased revenue streams for issuers and indexers, and competition to actively managed mutual funds.

Fund launches follow the popularization of academic research. First came the Fama/French size and style suites in 1993 and 1995. 2003 saw an explosion of smart-beta ETFs: dividend-focused funds, fundamentally weighted funds and even the first multifactor funds launched. The most recent wave, starting in 2011, has seen the expansion of factor investing beyond the style box, with volatility, momentum and multifactor funds attracting investor capital.

Index providers, ETF issuers and investors can all benefit—potentially—from the increased opportunity set. But with opportunity comes increased responsibility to understand these products. A quick look into some of the most popular funds from each of these eras illustrates the theory, opportunities and risks inherent in each.

Figures 1 and 2 provide a performance analysis and portfolio breakdown of six popular "strategic beta" U.S. large-cap equity funds compared to the iShares Russell 1000 ETF (IWB | A-94).

The Style Box 
The iShares Russell 1000 Value (IWD | A-87) and the iShares Russell 2000 (IWM | A-85) base their value proposition directly on the work of Eugene Fama and Ken French, who found that, from 1963-1990, small firms and value stocks outperformed the broad market. Although Fama and French's subsequent research has found a diminution or disappearance of the small-cap and value premia in most cases, the "style box" investing that their research inspired lives on.

A quick glance at Figure 1 shows that the most popular U.S. large-cap value and small-cap ETFs' returns are highly correlated to the Russell 1000—especially IWD, which posts an overall 98% goodness-of-fit to IWB. Both strategies are also riskier (higher beta) than the Russell 1000. Each of these approaches generally outperforms in rising markets but underperforms when the equity markets are under pressure.

ETF Explainer: INDA
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Backing In To Value 
Two variants on value investing—emphasizing dividends and financial statement fundamentals rather than price/book ratios—have caught investor attention. In the U.S. large-cap space, the WisdomTree LargeCap Dividend (DLN | A-92) and the PowerShares FTSE RAFI US 1000 (PRF | A-88) are the dominant dividend and fundamental ETFs, respectively.


Dividend investing relies on the theory that consistent, significant payouts to shareholders are a mark of quality. Fundamental indexing theory holds that a fundamental valuation avoids overweighting overvalued firms.

On a value scale, PRF and DLN sit between IWB and IWD. Both funds' most recent price/earnings ratios are notably lower than broad-based IWB's (Figure 2). PRF's price/book ratio of 2.2 is well below IWB's 2.8.


Performancewise, PRF has been very similar to IWD, except during the 2009-11 recovery. DLN's returns have been less volatile than IWD's, except, unfortunately, during the 2007-09 meltdown.

PRF's avoidance of overvalued securities did not prevent steep losses during the market meltdown, but its subsequent rebound made up for those steep losses. A fortuitous March 2009 index rebalance pushed PRF heavily into bank stocks, increasing the fund's beta just as the markets recovered. PRF investors were not as lucky during the most recent market run-up, from October 2011 to December 2014, when PRF's returns were nearly indistinguishable from IWB's.

Beyond The Style Box 
Researchers continue to investigate factors beyond size and value. Two outside-the-style-box factors that have attracted significant investor interest are volatility and momentum.

Invesco PowerShares' strategic beta blockbuster, the PowerShares S&P 500 Low Volatility fund (SPLV | A-47), which launched in 2011, focuses on securities that have low trailing 12-month volatilities. Although the low-volatility anomaly—the tendency of low-volatility stocks to outperform high-volatility stocks on a risk-adjusted basis over long time horizons—was discovered by Fischer Black and Myron Scholes in the 1970s, investors largely ignored it until two market crashes in a decade prompted interest in defensive strategies.


The S&P 500 Low Volatility Index's claim to fame is downside protection, though SPLV has not yet endured a full market cycle. Since October 2011, SPLV's investors have experienced muted gains compared with IWB's. Then again, between SPLV's May 2011 launch and the October 2011 market bottom, SPLV lost only 5.7%, while IWB dropped 17.7%. Even so, SPLV's correlation to the Russell 1000 jumped to a 94% goodness-of-fit during the 2011 market turbulence.

The risk with SPLV is that low volatility may have become a crowded trade, full of defensive investors with big dreams, a new accident waiting to happen. SPLV's price/earnings ratio is a touch higher than IWB's, suggesting that its low-volatility stocks have been in high demand.

The PowerShares DWA Momentum (PDP | B-55) aims to exploit the so-called momentum anomaly—the tendency of stocks to "run"; that is, for winners to keep on winning. First documented by Narasimhan Jegadeesh and Sheridan Titman in 1993, momentum investing took far longer to gain investor interest than small-cap or value investing. PDP is the oldest and largest ETF to attempt to exploit the momentum anomaly—it's been around since 2007 and has $1.7 billion in assets under management.

Like SPLV, PDP is more correlated to the overall market during downswings than it is during good times. Worse, it underperformed IWB in the most recent market run-up, from October 2011. PDP has been quite risky, with a sky-high beta to IWB of 1.11 during the 2011 deficit showdown. PDP also features an expensive portfolio, with a January 2015 price/book ratio of 5.4 and a price/earnings ratio of 28.7.

The Futile Search For Alpha 
Despite their grounding in well-researched factors, these popular "strategic beta" funds have generally not delivered any risk-adjusted excess returns. Simply put, they have not generated any alpha, with one short-lived exception. Overall, these funds' returns are well explained by their risk.

Riskier funds like PRF have outperformed IWB, while tamer funds like DLN have underperformed.

Small-cap IWM and value-oriented IWD and PRF have fallen harder—and then bounced back harder—than IWB ever since the 2007 market top, though these three ETFs underperformed during the frothy 2006-07 period. Meanwhile, momentum-seeking PDP has underperformed during the most recent years.

Lower-risk DLN did pretty much the opposite—rose less and fell less—though it dropped harder than IWB in the 2007-09 meltdown. DLN came close to producing risk-adjusted outperformance during the deficit showdown, with an annualized 8.8% alpha that's close—91.6%—to statisticians' gold standard of a 95% certainty of escaping the margin of error.

SPLV is the only fund of the bunch to definitively punch through its margin of error to deliver statistically significant alpha—briefly. In the four months following its launch, SPLV produced 8.3% excess risk-adjusted returns (21.5% annualized) versus IWB, at 98.1% statistical significance. Wow. Since then, SPLV's returns have normalized, with no long-term risk-adjusted outperformance.

All of the strategies presented, including small-caps, value, dividends, fundamental indexing, low volatility and momentum, come in many varieties. Investors can find real differences in portfolio construction and returns within each strategy. The funds discussed here are the most popular—not necessarily the most extreme or best-constructed examples of each strategy. Other funds will present different risk/return profiles.


Choose Your Strategy 
Even if smart-beta funds don't deliver alpha, they have opened up an interesting world for indexers, ETF issuers and investors. Whether people's interests lie in risk control or risk exposure, the market is ready and eager for more innovation in index construction.

Indexers and fund sponsors have heeded the call. With a panoply of factors and weighting schemes available, the sell-side can easily produce new strategies.

And these new strategies are in the market at a propitious time. As increasing numbers of investors grow disillusioned with actively managed mutual funds, those who seek to differentiate themselves have an opportunity to escape active management's high fees and put their capital to work in cheaper, more tax-efficient strategic-beta funds.

The investor bears the due diligence burden. Do beware of the madness of crowds. As these strategies become more popular, they are more prone to overvaluation and to liquidity shocks. As we saw in May 2013, when the low-volatility funds lost their alpha, the forces that pushed investors into smart beta can pull them out again in a hurry. Do your homework, understand your portfolio exposure and decide which risks you want to take.



Elisabeth Kashner is FactSet's director of ETF research. She is responsible for the methodology powering FactSet's Analytics system, providing leadership in data quality, investment analysis and ETF classification. Kashner also serves as co-head of the San Francisco chapter of Women in ETFs.