Strategic beta basics

Subtract humans

Remove some of that human element – the day to day management, personal stock picking and market timing attempts – and replace it instead with engineered algorithms, computerized company assessments and a carefully crafted screen for stocks, and you have something that lands between the realms of active and passive management.

The ‘Beta’ component in strategic beta comes from how the investment responds to swings in the market, and the desire to catch more of the upside, and less of the downside, says Andrew Clee, Vice President, ETFs at Fidelity Investments Canada.

Strategic beta comes from over 40 years of academic research that has looked at both why investments give investors returns and the role that risk plays in the equation, says Johnson. The theory is that by removing human behavioural biases, cutting through the noise and avoiding concentration risk of companies in an index, you’ll have the kind of beta that beats both active and purely passive bets.

“There is a ton of evidence that stock picking doesn’t work that great and neither does market timing, but there is lots of evidence that you can beat the market by holding certain variables or characteristics - and by holding them you can do better than a market cap index,” says Johnson.

The ability to outperform an actively managed approach, as well as a passively managed broad index approach is enticing. These approaches are also much more cost-effective than their active counterparts, but pricier than purely passive plays because of what goes into the index that they track.

Build an index 

Similar to a passive investing approach, a strategic beta tracks an index. But it isn’t your everyday index. In some cases, it’s a factor-based index, such as a value index, created by an independent index provider. But in a practice that is becoming more frequent with the rise in popularity of strategic beta ETFs, it’s a custom-designed index just for a specific product that has been engineered by quantitative analysts.

Once the product has been launched with the bespoke index, it’s hands-off from humans (until the next rebalancing). This quantitative approach results in “a product that behaves as its designed,” says Clee. The design that goes into these indexes often involves a filtering process through a universe of companies to isolate those stocks that provide the desired level of exposure to the factors that the index is designed around.

For example, Fidelity’s process “first defines a universe of around a thousand stocks to start,” says Clee, then selects companies with attributes that enhance exposure to a given factor followed by a screen for quality-assurance, picking out stocks that might be suspect and ensuring there is no concentration risk among too few companies. The Fidelity Canadian High Quality Index ETF (FCCQ) uses an index that defines quality in companies as those with solid profits, strong balance sheets and stable cash flows.

You can also take a multi-factor approach to strategic beta, as does SmartBe. The SmartBe Global Value Momentum Trend Index ETF (SBEA) uses an index based on three factors combined: value, momentum and trend-following.

Focus on the factor risk

There is still a human element that remains, in that there will be a need to pick the right factors to follow, at the right time.

At the investor level, “not all factors are ‘one-size-fits-all’”, adds Clee, saying that the investor’s personal situation plays an important part in the factor selection process. Some investors require income and should focus on the dividend factor. Others might have longer time horizons and have the potential for higher returns with a momentum focus.

Investors should also pick the right factors for the market.

“Factor investing is science if there is fair reason to believe that a manager can identify factors with a positive expected alpha—until the factor becomes a crowded trade and the expected excess return flips to negative,” wrote Larry Siegel, Director of Research at the CFA Institute Research Foundation, in an article for Morningstar magazine, “It’s hard to see how any factor can work forever”.

Clee adds that investors should anticipate that a strategic beta approach will differ from a benchmark – hence the beta – and that they should adopt a goals-based lens, for this goals-based solution.

Both Clee and Johnson agree that it’s important to know whether you’re making big bets you might not be aware of. “They require more active due diligence,” says Clee. Many strategic beta products have too much of the market in them because the manufacturer thinks clients won’t like something that looks too different from the index, Johnson adds.

“Look for high active share strategic beta,” says Johnson, or hire a great discretionary broker to help you. Active share is a holdings-based measure of to what extent a portfolio differs from its benchmark. For a strategic beta portfolio, the benchmark would be the market-cap weighted index of the universe of stocks from which it is derived.