Emma Wall: Hello and welcome to the Morningstar European Investment Conference. I am Emma Wall and here with me today is Ben Johnson, Director of Passive Manager Research for Morningstar. Hi, Ben.
Ben Johnson: Hi, Emma.
Wall: So we are here today to talk about Strategic Beta. It's what some people know as Smart Beta. Why have we chosen at Morningstar to get rid of that Smart moniker?
Johnson: Smart, first and foremost, is frankly a dumb term and it's a marketing term. And what I think the term Smart does, first and foremost, is it misleads investors, because, quite frankly, not all of these various strategies are smart and even the ones that are very smartly constructed are not going to necessarily feel all of that smart over any given period.
They are going to have their own unique performance patterns. They are going to underperform in certain market environments. They are going to lag the market in certain market environments. So when we approached this topic, the first thing we did was kick the term Smart to the curb.
Wall: And I think that touches on some of the risks that are in Strategic Beta and in fact, are in any sort of faddy investment; gold was you know victim to this, emerging markets were victim to this. It's the thought that these strategies can only go one way, which is up and in fact, they don't always go that way. I mean what are the other risks associated with Strategic Beta?
Johnson: Well, I think the chief risk is a failure to manage one's expectations appropriately and this is not unique to Strategic Beta. This takes place in the context of traditional index funds. It takes place in the context of active strategies. The most sensible thing investors can do is pick a sensible strategy, but then more importantly, to stick with it through thick and thin. So I think the chief risk as it pertains to Strategic Beta, if one doesn't approach these strategies with the appropriate expectations is that they will not use them smartly.
We're back to the term smart again, and that's the chief risk because certain strategies will outperform in a given market. They will look really poor in other markets. And when they look the poorest, really things are darkest before the dawn, and that's actually when the expected outperformance on a go-forward basis is the greatest. But what we see is that's also the same time where investors tend to abandon these strategies. So the chief risk from my point of view is that these are utilised poorly by investors.
Wall: This is a massively growing, what you called, subsection of the fastest-growing section of investment, ETFs. There are maybe 600 worldwide, assets under management in Europe grew 50% last year, in the U.S. 25% or thereabouts. How do investors sort the wheat from the chaff? I mean how of those 600, do you choose the one that's right for you?
Johnson: Well, I think for the sake of simplicity, there are two things that I think investors should focus on. I think first and foremost it is cost. I think investors should focus on costs in virtually all contexts, but I think in this context, it's particularly important because in many cases index providers, ETF providers are using this sort of innovation, this increased complexity as a way to justify relatively higher fees vis-a -vis a traditional broad-based market index exposure. And in that segment of the market what we're seeing is a very heated fee war, whereby exposure to the FTSE 100 or the S&P 500 has gotten to the point where it's nearly free. It's nearly costless. So focusing on fees is important.
Now what we're talking about in these strategies is old wine in new bottles. The advantage of the new bottle is that it's relatively cheaper vis-a-vis active managers. That said, there's a segment of these strategies that are passive strategies that charge near active management prices. Investors should think twice and probably thrice before they pay active prices for passive strategies. So that's step one.
Step two I would say is and it's really closely related to step one, is to look for a capable, responsible sponsor. So an asset manager that has indexing as a core competency, that has a wealth of experience when it comes to running index funds. This is particularly important in this context, given that the particulars of managing to these indexes are a bit more complex relative to a broad market exposure.
It's also important because a capable and responsible sponsor is going to emphasise launching investable strategies that have lasting investment merit and likely doing so at a low-cost as opposed to just chasing a fad and emphasizing marketability over a strategy's actual investment merit. So costs and stewardship are really the two key points that I would emphasise.
Wall: Thank you very much.
Johnson: Thank you, Emma.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
Emma Wall is Web Editor for Morningstar.co.uk.
