Dear all,

Please find below a good article as appeared in Morning Star for your reading:

What exactly is smart beta?

"Smart beta," "alternative beta," "enhanced indices," "fundamental indices" "quantamental indices"-- there's a list of monikers to describe the expanding middle ground between active and passive funds. The need to define this space, to measure it and to police it has grown and will continue to grow.

Strategic beta aims to improve on traditional indexing, yet retain its transparency, low turnover, tax efficiency and low fees. It is one of the fastest-growing sectors in the fund industry and is popular in others markets too, such as Australia.

Active managers consider many factors but ultimately judgment is key. In contrast, on the passive side, traditional indices use rules, not judgment. The primary rule is market cap. Even if a company is expensive, if it's big, it should loom large in a market-cap-weighted index.

Strategic beta lies somewhere in between -- it is rules-based but goes beyond market cap. Other factors drive portfolio make-up, such as value, momentum, quality, volatility or income.

Why Morningstar refers to it as strategic beta

The need to define this space, to measure it, and to police it has grown and will continue to grow with time. At Morningstar, we have decided to tag this realm with the label strategic beta.

Why strategic beta?

First and foremost, we are eager to do away with the positive connotations that may be inferred by the "smart" in smart beta. Not all of the strategies included in this arena are smart, per se. The term strategic is meant to draw attention to the fact that the benchmark indexes underlying the ETPs, mutual funds, and other investment products in this space are designed with a strategic objective in mind. These objectives primarily include attempting to improve performance relative to a traditional market-capitalization-weighted index or altering the level of risk relative to a standard benchmark.

As for the beta in the name, it is not meant to imply beta in the strictest, most academic sense of the term (a measure of a security or portfolio's sensitivity to movements in the broader market). Instead, it is to highlight the fact that this is a group of index-linked investments, all of which have the goal of achieving a beta equal to 1 as measured against their benchmark indexes.

Strategic beta may not roll off the tongue as easily as smart beta, but we believe it is a more accurate descriptor--one that doesn't imply that this universe is the index world's equivalent of Lake Woebegon.

It should be noted that these are merely attribute tags and not new fund categories, just as we do not have a "passive" or an "active" category. The portfolios of strategic beta funds exhibit a variety of investment styles. Our purpose in creating these descriptions is to help investors rigorously analyse this breed of funds, facilitating comparisons between those with similar strategies as well as within the context of their traditional Morningstar category.

The 5 principles of a good strategic beta approach

1) Low cost

An absence of stock-forecasting or macroeconomic predictions means a large investment team is not required. A straightforward approach should cost little more than passive indexing. More complex strategies may be priced at a premium but should still be cheaper than active management.

2) Sensible index construction

The factors selected must be well-considered. They should be either durable predictors of return, or if not durable, there must be scope to adjust factors over time in a transparent way. Alternatively, factors may not target outperformance but some quality of return that investors demand (for example, high income or low volatility).

3) Capable people

Those behind the strategy must have an understanding of financial theory, market reality, as well as expertise in trading/execution.

4) A wide investment universe

An advantage of strategic beta is the ability to use computers to process a wide array of information. For example, RealIndex can quickly compare the price/book and price/earnings ratios for every major stock in the emerging markets universe. If there is only a small universe, or the universe is skewed, active managers may be better equipped. The Australian market, dominated by a handful of banking and resource stocks, is vulnerable in that regard.

5) Good data

Strategic beta is only as good as the quality of the data. Accounting data (for example, sales and balance sheet figures) can vary greatly. Data must be consistent across countries and industries, or alternatively, it must be rigorously standardised.

A number of strategic-beta approaches have long track records of success and we agree there is some logic to constructing indices using factors beyond just market cap. After all, just because a company is big does not necessarily mean it's a good investment.

But investors must understand what they are buying and why. Strategic beta is not a panacea and inevitably these strategies will go through difficult periods. For example, income-biased strategies will suffer if high-dividend stocks underperform -- an easily imaginable scenario given their strong performance in recent years.

Value strategies may suffer when the economy is weak or when risk aversion spikes. But given strategic beta's relative transparency, investors should have little to complain about so long as they have done their homework.

The text for this article has been written by Ben Johnson, global director of manager research for passive strategies, Morningstar, and Alex Prineas, a Morningstar fund research analyst.

regards

aknarayan