Global investing—literally and figuratively—is foreign to many US investors. That’s why some have taken a passive approach that’s designed to track the performance of an index such as the MSCI All Country World Index (MSCI ACWI). For several decades, market capitalization-weighted indexes like the MSCI ACWI (for global investing) and the S&P 500 Index (for US large-cap investing) have served as the foundation of a passive approach to investing. Yet today, more advanced approaches to index construction may help improve upon this traditional approach. One such methodology, called Strategic Beta, involves constructing indexes based on criteria other than market capitalization. Exchange-traded funds (ETFs) are then designed to track these custom indexes.
Broad Market Exposure, with Shortcomings
Did you know that the largest 5% of stocks in the MSCI ACWI comprise 41% of the index’s weight? Traditional indexes weight stocks based on each company’s overall market capitalization, meaning the largest, highest-priced companies make up the largest portion of an index. These indexes also periodically rebalance to maintain these market-cap based weightings, increasing their allocations to stocks that rise in price and reducing their allocations to those that fall in price, without considering whether the stocks are over- or under-valued. The trouble is that this could lead to heavier concentrations of overvalued securities. New methods of index construction, such as Strategic Beta, have now emerged, offering additional ways for investors to gain exposure to specific areas of the market. Strategic Beta is often based on quantitative methodologies originally designed for large institutional investors that have recently become available in ETFs designed for individual investors.
Understanding Strategic Beta
Many Strategic Beta portfolios systematically analyze, select, weight and rebalance portfolio holdings based on certain characteristics—called factors—with some portfolios focusing on a single factor and others combining multiple factors into a single portfolio. As far back as the 1930s, professional investors began to recognize that stocks with different attributes tended to perform better than others. Then, starting in the 1970s, academic research demonstrated that stocks with certain factors have at times produced higher returns than the overall market. Today, methodologies based on these quantitative factors form the foundation for Strategic Beta indexes.
What Is a Factor?
A factor is a primary characteristic of a stock that explains its behavior over long periods of time. Think of a factor as a DNA marker of a stock that indicates how it responds to certain events, driving its price over time. Stocks can be grouped based on the primary factors they share. Factors that have provided investors with positive returns above and beyond market indexes over the long term—called a “return premium”—include Quality, Value, Momentum, and Volatility. Some other factors have been more closely associated with stock risk.
A Case in Point: The Quality Premium
Over time, the stock prices of high-quality companies have increased more than other stocks. The chart above illustrates how a hypothetical investment in high-quality stocks (as measured by the MSCI ACWI Quality Index) would have gained more than an investment in the broader MSCI ACWI over the time period shown.
Every Factor Has Its Day
Some investors may be inclined to choose one or two factors for investment, but this approach can come with its ups and downs. As you’ll see in the chart below, Quality, Value, Momentum or Minimum-Volatility stocks by themselves have moved in and out of favor as markets have changed. It’s understandable that many investors may prefer a multi-factor approach that helps smooth out these ups and downs and avoids the need to time factor exposures.
Applying Multiple Factors: Innovation in Index Design
Multi-factor Strategic Beta draws on analysis of how various factors interact, which allows a manager to diversify among factors in a way that seeks to reduce risk and increase return potential over time. This analysis also informs the relative weightings of factors in a Strategic Beta ETF portfolio to pursue specific portfolio attributes and potential investment outcomes. An investor who holds a more advanced, multi-factor portfolio may be better diversified, does not need to try to time factor cycles, and doesn’t incur the costs that come with switching from one product to another as they attempt such timing.