Strategic-beta ETFs: Wisdom or madness?

While such a strong degree of skepticism may be over the top, it reminds us that we should never take any investment product for granted. In particular when considering a strategic-beta ETF, we need to carefully ponder the following questions:

Do you accept the premise of the strategy in question?

The ideas for the strategic-beta approaches grew out of two strands of ideas. One is the notion of factor investing, in which a portfolio is tilted toward exposure to one or more factors that historically have produced returns superior to those of the market over long periods.

For equity portfolios, these factors include value (cheap outperforms expensive), size (small outperforms large), momentum (recent relative winners outperform recent losers), liquidity and volatility (low volatility outperforms high volatility).

The other strand is the idea of using non-market-value weights, especially weights based on company fundamentals as introduced by Rob Arnott and his firm Research Affiliates.

Many strategic-beta approaches both tilt toward factors and use non-market-value weighting schemes. (Morningstar's definition of strategic beta includes approaches that tilt toward factors, but use a market-value weighting.)

There is a great deal of debate as to why tilting toward certain factors has produced superior performance over the market portfolio. Some adherents to the efficient-market hypothesis (EMH) claim that a premium associated with a factor is compensation for taking some sort of risk. In the anti-EMH camp, there are behavioural theories in which factor premiums are the result of irrational investment behaviour.

Regardless of the reason that factor tilting works (or at least has worked in the past), since all investors collectively make up the market, if there is a group of investors who are systematically outperforming the market, there must be investors who are underperforming the market. This principle was first annunciated by Nobel laureate William Sharpe in 1991.

Based on this principle, Arnott coined the term "willing loser" to describe those on the losing side. As cited by Knut Rostad in his 2013 book The Man in the Arena: Vanguard Founder John C. Bogle and His Lifelong Battle to Serve Investors First, Arnott said: "If we depart from cap-weighted indexation, we do well to recognize that we can beat the market only if someone on the other side of our trades is a willing loser." Hence, the premise for any strategic-beta approach should include the identity of the willing losers.

Can you withstand periods of underperformance?

Even the best strategy cannot beat the market portfolio at all times. There will always be periods of underperformance.

Consider, for example, one of the oldest strategic-beta ETFs in Canada:  iShares Canadian Fundamental Index (CRQ). Launched in February 2006, it tracks the FTSE RAFI Canada Index.

Overall since its inception, this ETF has outperformed its passive sibling,  iShares Core S&P/TSX Capped Composite Index (XIC), which tracks the market benchmark. However, in four of its nine full calendar years, CRQ has lagged XIC. These include 2015, when CRQ's loss of 11.5% was 3.2 percentage points worse than XIC, and 2014, when CRQ's 6.4% return trailed XIC by four full percentage points.

As Rob Arnott has observed: "Fundamental index portfolios have a value tilt, and that's going to help you when value wins and hurt you when it loses. Has it lived up to people's expectations? No. A lot of folks heard what they wanted to hear -- long-term value added -- and assumed that meant all of the time. That's just not realistic." (Wall Street Journal, April 6, 2009)

A strategy that back-tests well can end up being disappointing in real time, especially after costs. This is not to say that the strategy will not outperform in the future. It is that no matter how strong your conviction in a strategy, you need to be able to bear periods of underperformance.

Do you think that past performance is due to an intrinsic premium-generating process or growth in the popularity of the strategy?

We are all familiar with the disclaimer that goes with just about any investment product and says that past performance is not necessarily indicative of future results. No kidding. But Rob Arnott and some of his colleagues at Research Affiliates have gone one step further. They write:

"We foresee the reasonable probability of a smart beta crash as a consequence of the soaring popularity of factor-tilt strategies." (How Can "Smart Beta" Go Horribly Wrong?, February 2016) 

In other words, if the past success of a strategic beta product was due to investors driving up its price rather than because the strategy was harvesting a factor-based premium, at some point the price must come down. This is an application of Stein's Law: "If something cannot go on forever, it will stop."

I do not know if Arnott is right; only time will tell. But, he is raising an important point about strategic beta that should be considered before investing in ETFs that track these strategies.

Are the fees worth it?

Cost is always an important factor in deciding which investor products to buy. For example, in Canada, investors can get exposure to the Canadian stock market for an expense ratio of as little as 0.03%. But once you move from broad market exposure to strategic beta, the expense ratio jumps to between 0.33% and 0.79%, depending on the strategy and the ETF provider.

Returning to our earlier comparison, a strategic-beta mandate like iShares Canadian Fundamental Index generally has a higher fee hurdle to overcome than its much cheaper passive counterpart. Its currently reported expense ratio is 0.72%, compared with just 0.06% for iShares Core S&P/TSX Capped Composite Index.

While expense ratios on strategic-beta ETFs are far lower than those on traditional active mutual funds, they are high relative to those of broad market-weighted indexes. Costs always matter, so they should always be taken into account when selecting investment products.

For example, let's say you invest in an ETF that has an expense ratio of 0.06%; with a gross return of 5% over 10 years, a $1,000 investment would grow to $1,619. However, if the expense ratio were 0.72%, with the same gross return of 5%, the investment would grow to only $1,515.

So an investment in any strategic beta ETF is a bet that the strategy will outperform the market portfolio by at least the difference in the expense ratios of the ETF in question and that of a low-cost market-index ETF.

Conclusion

All investment products should be examined with some scrutiny before investing. Given the proliferation of strategic beta ETFs, it would be a mistake to discount them all in a single stroke. But it would equally be a mistake to accept all of them as good investments. Inevitably, some will succeed and some will fail.

By taking a deeper look into what it behind them, we may be able tell which ones will succeed or fail in the long run. In other words, we may be able to tell which ones are gaining popularity due the "wisdom of crowds" and which ones are doing so because of the "madness of crowds."

Editor's note: The original version of this article appeared in the April/May 2016 issue of Morningstar magazine.