Smart beta ETFs are set to attract assets from both active managers and passive indexes, many providers and analysts say.

In a recent article on the topic by another SourceMedia brand,Financial Planning, David Koenig, investment strategist at Russell Investments, which has created widely used smart beta indexes, explained:

"Smart beta sits right in the middle of what has been considered beta and what has been considered alpha. Part of what had been attributed to manager skill can be accounted for by exposure to certain factors." These include company size, stock price momentum and price to book value ratios that computers can efficiently discern.What do mutual fund and ETF providers need to know as smart beta products proliferate? Scott Kubie, chief investment strategist of CLS Investments, explains.

Q: J.P. Morgan Chase, the most recent entrant to the ETF market, didn't use the term smart beta in its recent launch of JPMorgan Diversified Return Global Equity ETF (JPGE). Are some providers fearful of the label? Why?

"Smart beta" is a popular marketing term that reinforces the advantages of factor-based strategies. However, this makes capitalization-weighted strategies providers of "dumb beta." When you compare the results of "dumb beta" versus many active strategies, dumb beta looks pretty smart! I've been part of a number of panels and private discussions at conferences where people expressed their dissatisfaction with "smart beta." My sense is providers also looked at the historical results and realized these strategies can underperform for extended periods of time. Calling them "strategic beta," gives investors a better idea of what they are and the holding period required to realize their benefits.

Q: You have said in an earlier conversation that the smart beta trend would have started a lot earlier if it weren't for the financial crisis undercutting people's confidence in financial expertise. Can you give an example?

PowerShares FTSE RAFI 1000 (PRF) passed $1.2 billion in assets in October, 2007. By February, 2009 it was just over $300 million. From there it resumed its growth trend and is now over $3 billion.

Q: ETF providers have been launching a variety of strategic beta ETFs. What's driving the push?

Some asset managers are launching strategic beta strategies to complement active mutual fund lineups. JP Morgan just launched their first ETF and it is clearly in the strategic beta camp. Like many mutual fund firms, JP Morgan ran the risk of falling too far behind in the ETF space and needed to establish a strategic foothold. It also has an excellent global quant team that produces great research. That insight just found its way into one of the more innovative strategic beta ETFs on the market.

Q: As more baby boomers enter retirement, the emphasis on risk management will continue to grow. How are mutual fund families responding to the threat?

Some of the mutual fund providers, such as T. Rowe Price, have responded by filing for nontransparent or active ETFs. No one is sure how long it will take to launch these strategies and how quickly they will be embraced. Others have passed on the opportunity so far. Janus, for example, has an Intech subsidiary whose strategies would seemingly translate well into strategic beta ETFs. Yet they have not launched any.One effect of strategic beta ETFs is that existing actively managed mutual funds are likely to zero in more on proprietary insights and to increase their focus on the manager's best ideas. That means actively managed mutual funds will get riskier.

Q: What do fund providers need to do in order to a) distribute b) operate and c) market such products effectively?

The strategic beta ETF market is potentially more scalable than actively managed mutual funds. If an active mutual fund manager is good at small caps they may not have the time to develop those same insights for large value stocks. On the other hand a strategic beta approach can be readily adapted to different market segments.

The distribution team becomes advocates for the philosophy as well as each particular application. Strategic beta strategies also benefit from strong support by the investment management team.The distribution team must be prepared to answer questions about how the strategy fits into an overall allocation. What should it replace? How large of an allocation should it receive? Operationally, the strongest firms we work with have excellent partnerships with the index and risk management firms. The best firms are sharing information about periods of time when there strategy underperformed, by how much, and how the portfolio has changed overtime. Even strategies that don't use optimizations benefit from a strong risk management capability. Marketing strategic beta strategies reminds me of a political campaign. The goal is to stay relentlessly on message. Both DFA and Research Affiliates do an amazing job of emphasizing their core message in nearly everything they do.

Finding simple explanations and language so an advisor can provide a basic explanation of the strategy to the client is crucial. The strategy expert mentioned above should also publish white papers exploring the strengths and weakness of the strategy.

The white papers and expertise helps establish credibility and trust with customers.

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