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Strategic beta ETFs combine the best aspects of active management and passive indexing to help investors achieve specific investment outcomes
<p>Strategic beta ETFs combine the best aspects of active management and passive indexing to help investors achieve specific investment outcomes.</p>

Placing Strategic Beta ETFs Under The Portfolio Microscope

Strategic beta ETFs had $402 billion in total assets at year-end 2014

Investor demand for strategic beta exchange-traded funds (ETFs) continues to increase, reflecting the continuing appetite on the part of financial advisors and their clients for access to top-quality, quantitative investment expertise through transparent, liquid and low-cost products. According to Morningstar data, strategic beta ETFs had $402 billion in total assets at year-end 2014, and recorded inflows relative to assets of 19%, compared to 13% for their non-strategic-beta counterparts.

Strategic beta ETFs combine the best aspects of active management and passive indexing to help investors achieve specific investment outcomes, such as lower risk, excess returns, more income or greater diversification. Instead of weighting companies in underlying indexes by market capitalization (like most ETFs), strategic beta ETFs either weight companies using rules-based criteria such as cash flow or targeted volatility levels, or equally weight them. In this way, strategic beta ETFs combine elements of actively managed mutual funds with the lower fees and   transparency associated with ETFs. The result is a precise investment that can be used to build a better portfolio.

Products Rely on Underlying Index Providers’ Expertise

Strategic beta ETFs can complement both active and passive products in client portfolios to create more predictable routes for clients to reach their desired outcomes. The keys to their success are the methodologies of their underlying index providers. The precise, targeted nature of strategic beta ETFs require the index providers behind them to be experts. As in the actively managed mutual fund world, the skills, experience and credibility of each strategic beta index provider should be carefully analyzed before investing.

For example, Santa Barbara, Calif.-based equity research shop Sabrient Systems LLC uses a unique quantitative approach to index construction. Sabrient’s approach combines alpha-producing strategies with strategies seeking beta exposure to sectors, market niches and style boxes. Sabrient’s approach has demonstrated an enviable record of outperformance. Investment vehicles with over $5 billion in collective assets track them, including our firm’s Direxion All Cap Insider Sentiment Shares ETF (KNOW), a strategic beta ETF focused on delivering excess returns.

Peeking Inside Portfolios Invested in Strategic Beta ETFs

Many retail and institutional investors find strategic beta ETFs to be useful, low-cost instruments. While attending a recent industry conference, I spoke with advisors who explained how strategic beta ETFs function within their clients’ portfolios. 

One advisor relayed that some of his clients use a strategic beta ETF designed to generate excess returns in their portfolios’ alpha buckets. His clients like the underlying index provider’s methodology because companies are selected based on company data, analyst rankings and other quantitative criteria. Companies with poor or opaque accounting are weeded out. Clients like this approach because they feel like corporate insiders are making stock-selection decisions rather than analysts with general investing knowledge. Fee budgeting is also an important consideration. The ETF’s reasonable 65-basis-point fee provides the advisor’s clients with an inexpensive quantitative strategy that seeks to achieve the same goals as more expensive mutual funds. 

Another advisor discussed a strategic beta ETF that tracks an equally-weighted index composed of master limited partnerships (MLPs) and attempts to help investors generate more income. He explained that his clients use this product as an alternative to fixed income or as part of a general income strategy. In fact, some of the advisor’s clients have evenly split their portfolios’ income buckets between this ETF and another market-cap-weighted MLP index ETF that follows the same benchmark. This combined allocation provides higher income and a smoother ride to desired investment outcomes.

In addition, a third advisor extolled the effectiveness of a strategic beta ETF tracking the S&P 500 Volatility Response Index (VIX) in delivering an investment outcome of lower volatility. His clients use this ETF to replace part of their large-cap equity exposure because they can stay invested in S&P 500 stocks knowing the dynamic nature of the index provides a degree of downside protection when volatility increases. With over 200 client accounts, the advisor found this ETF a useful tool that was easily implemented.

A Reliable Way to Reach Investment Outcomes

As these brief stories demonstrate, strategic beta ETFs offer cost-effective opportunities to enhance investment results—and can do so as core or complementary portfolio allocations. These products are ideal for obtaining low-cost, transparent access to methodologies and strategies of high-quality investment organizations.

Brian Jacobs is President of Direxion Investments ( 

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