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Understanding Strategic Beta

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2:07 | Transcript

You've made the decision to incorporate strategic beta ETFs into your portfolio. If you are an individual investor you may have heard the term but aren't sure what strategic beta is. Likewise for financial advisors, you feel that some strategic beta strategies make sense for your clients but are looking for the best way to explain the value of this approach to them.

For advisors, how do you explain strategic beta to your clients? More importantly, how do you explain the benefits of incorporating strategic beta strategies into their portfolios? Here are some thoughts for both individual investors and financial advisors.


Beta is an assessment of volatility or systematic risk tied to a portfolio or an individual security that is considered in relation to the overall market. Systematic risk is the risk that cannot be easily diversified away.

Strategic beta has many definitions, but it generally involves the use of alternative structures of traditional, market cap-weighted indexes like the S&P 500 or the Russell 2000. The term "factor investing" is used often here.

Strategic beta is more commonly referred to as smart beta in the investment industry and by the financial press. We here at FlexShares feel that smart beta isn't always "smart" and that the use of factors is more of a strategic tool for investors to use in fine-tuning their asset allocation.

Factors are portions of traditional, market cap-weighted indexes. Factors are not new. Factors like value have been around for years. For example, there are several ETFs that invest in the value portion of large cap benchmarks like the Russell 1000 and the S&P 500 indexes.

In recent years, factor investing has allowed investors to become more granular in their asset allocation.

Popular investing factors include:

Investing factors

Investing factors

An ETF based upon the quality factor will track an index designed to reflect a quality tilt and the manager will follow a set of rules established for when and how to rebalance and reconstitute the portfolio. These rules are tied into the creation of an index-based benchmark highlighting the factor or factors used in the ETF strategy, including any factor tilts such small cap and/or value for non- U.S. developed markets, the U.S. stock market, and other markets.

For example, our FlexShares Morningstar® U.S. Market Factor Tilt Index Fund (TILT) utilizes a proprietary index that defines the U.S. market as the top 99.5% of the investment U.S. stock market. The index provides increased exposure, or tilts the weighting, toward small cap and value stocks within this investable universe. Candidates are screened each year and assigned to the appropriate boxes within the universe. The ETF is then rebalanced to reflect these new weightings.

"Factor investing" might be a better name than "strategic beta" for this type of investing approach.


Strategic beta ETF strategies are not only limited to equities but are also applicable to the fixed income side of investments as well. However, the number of smart beta fixed income ETFs is dwarfed by the number of equity-based strategies.

Why is this? Various reasons have been suggested, including a lack of academic research compared with the equity side. We here at FlexShares have several strategic beta fixed income strategies based upon factors such as credit scoring and duration. We believe that these allow investors and financial advisors to better manage this part of their portfolio's allocation.

Not every strategic beta strategy is right for all investors.


A market cap-weighted index ETF that tracks an index like the S&P 500 will be allocated in the same fashion as the index. This means that potentially over time certain stocks with the biggest market cap potentially could have a larger influence on the index and the performance of the ETF.

Strategic beta ETFs using one or more factors are different in that they use rules for security selection, using screens to find the securities included in the ETF. Typically, the benchmark methodology rescreens the eligible universe of securities, such as U.S. large cap stocks, emerging or developed market stocks, and a host of others at pre-determined intervals.


The bottom line for investors and financial advisor clients is this: What are the benefits of incorporating strategic beta strategies into portfolios?

The advantages of using strategic beta strategies for investors include:

  • Potential for improved and more consistent returns.
  • Ability to better manage risk.
  • Opportunities for increased dividend income.
  • Greater efficiency and granularity in gaining exposure to certain areas of the markets.

Using appropriate strategic beta ETFs can help you better align portfolios to meet investment goals and objectives, keeping in mind risk tolerance and time horizon. Strategic beta ETFs are another investing tool in your tool kit. Not every strategic beta strategy is right for all investors nor are the offerings of every ETF provider offering factor-based ETFs. The issue is determining whether incorporating smart beta strategies into your portfolio is the right move, and looking under the hood of various factor-based strategies offered by different providers to decide which ones add value for them.

In analyzing strategic beta or factor based investing it is important to stress that the use of factors isn't new. Factors such as size, value and dividend strategies have been around for years. Strategic beta ETFs offer the advantages of indexing and ETFs, including low cost, tax efficiency, and transparency. The development of rules-based benchmarks and screens takes indexing to the next level, beyond the simple use of market weighted indexes where holdings are determined by their relative weight in the benchmark index.

Today's strategic beta ETFs allow investors to fine-tune their portfolios to manage risk, generate income, and focus on various attributes offered by different factor- based strategies. Strategic beta is not a cure for down markets. As with any other portfolio holding, these ETFs need to be monitored to ensure that they are performing as expected.


The FlexShares approach to index-based investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of any of the ETFs discussed in this report in greater depth or find out more about the index methodology behind them please don't hesitate to call us at 1-855-FlexETF (1-855-353-9383).

FlexShares Morningstar® U.S. Market Factor Tilt Index Fund (TILT) is subject to concentration risk. The Fund's investments are concentrated in the securities of issuers in a particular market, industry, sector or asset class. The Fund may be subject to increased price volatility and may be more susceptible to adverse economic, market, political or regulatory occurrences affecting that market, industry, sector or asset class. The Fund may also invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Fund could lose more than the principal amount invested.

The Morningstar® U.S. Market Factor Tilt Index is the intellectual property (including registered trademarks) of Morningstar® and/or its licensors ("Licensors"), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by Morningstar® and its Licensors and neither of the Licensors shall have any liability with respect thereto.