Strategic Beta ETFs Deserve a Second, Careful Look

Strategic beta ETFs are an important asset class to consider, but new research also warns many of the products “aren't as distinctive as they may first appear.”

New research from Morningstar, dubbed “A Global Guide to Strategic-Beta Exchange-Traded Products,” offers a helpful overview—and a word of caution—about the strategic beta exchange-traded fund (ETF) landscape.

Ben Johnson, Morningstar’s director of global ETF and passive strategies research, says one clear finding is that in the years to come, an increasingly crowded and competitive landscape will put pressure on fees.

“It remains to be seen whether incumbents’ fees will face pressure from competitors, investors, or both,” he explains.

Findings from the analysis show, as of June 30, 2017, there were 1,320 strategic-beta exchange-traded products, with collective assets under management of approximately $707 billion worldwide. Assets in these products grew an impressive 28.4% relative to their June 30, 2016 level, Morningstar reports.

As the research shows, the number of assets and funds in this space has grown much more rapidly than the broader ETF market as well as the broad asset management industry.  Johnson notes there were 204 new strategic-beta ETFs brought to market in the 12 months through June 2017, down slightly from 211 during the prior period.

“Morningstar has assigned Morningstar Analyst Ratings to 119 strategic-beta ETPs worldwide since November 2016,” Johnson adds. “These funds collectively held more than $495 billion in investors’ money as of June 30, 2017—representing 70% of the total amount invested in strategic-beta ETPs around the globe.”

Fueling the rapid expansion, Morningstar’s research finds, is in part the fact that the fees levied by strategic-beta ETFs are, on average, “competitive with those charged by the universe of ETFs ex-strategic beta.”

Crucial for investors to consider, the research is also frank about the limits of the emerging asset class. Morningstar’s separate Strategic Beta Performance Replication Study challenges some strategic-beta funds’ pricing by attempting to determine whether it is possible to replicate strategic-beta equity funds’ performance with various combinations of market-cap-weighted alternatives.

“Strategic-beta funds aren’t as distinctive as they may first appear. It’s possible to replicate most of their performance with size and value exposures that simple cap-weighted indexes can offer, suggesting that most of these funds just repackage market risk,” explains Alex Bryan, director of passive strategies research, North America. “Investors shouldn’t pay significantly higher fees for these strategies than market-cap-weighted alternatives, which capture the same performance drivers and can replicate most of their returns.”

The Morningstar researchers conclude that many strategic-beta funds are still worth investing in, even if their merits are sometimes exaggerated, as a large minority of strategic-beta funds did outperform their replicating portfolios. Additionally, the researchers feel it is “more efficient to purchase a strategic-beta fund than trying to reassemble its factor exposures, which often shift over time.”

More information and analysis is available from Morningstar here