Journal Of Strategic Investment Beta Strategies: Research .

Strategic beta strategies: An evaluation of different approachesExhibit 4 provides a sector analysis of sevenalternative weighting strategies and two marketcap indexes. These allocations differ becauseof their weighting methodologies. For example,look at the PowerShares S&P Low Volatilitystrategy, which has a 18.35% allocation toutilities and 16.49% to consumer staples. Thisdiffers from the other strategic beta strategies,whose allocations to utilities range from 3.03%to 9.38% and whose allocations to consumerstaples range from 5.59% to 14.33%. Thelow-volatility strategy has a greater emphasison utilities and consumer staples becausehistorically they have had less volatility thanother sectors. The low-volatility strategy alsomakes big bets on these two sectors relativeto the S&P 500: utilities (18.35% versus 3.24%)and consumer staples (16.49% versus 9.80%).The difference in sector allocations may lead todramatically different results over time—eitherhelping or hindering performance.Other differences across these strategies andrelative to the benchmarks (S&P 500 Indexand Russell 1000 Index) are byproducts of theweighting methodologies and the underlyingindexes rather than any intended bets on themarkets. Advisors should carefully considerthe underlying portfolios and some of theunintended bets.Market capitalization is another importantconsideration when evaluating these strategies.Exhibit 5 on page 6 provides a marketcapitalization breakdown across the strategiesand the two market-cap indexes. As shown, theDFA strategy has the highest allocation to smallcap and microcap stocks (12.04% and 4.19%,respectively). DFA relies on work conducted byEugene Fama and Ken French.Fama and French attempted to attribute marketreturns and found that value stocks have tendedto outperform growth stocks; similarly, smallcap stocks have tended to outperform large-capstocks over time.7 There is a lot of debate aboutExhibit 4Sector allocations careTelecomservicesEnergyIndustrialsInfo techSchwab Fundamental U.S.Large Company 3.78DFA US Core Equity 1Portfolio I 05First Trust Large Cap CoreAlphaDEX Fund Guggenheim S&P 500 EqualWeight ETF PowerShares FTSE RAFIUS 1000 Portfolio 18PowerShares S&P 500Low Volatility 12.112.81WisdomTree LargeCapDividend Fund 3Russell 1000 S&P 500 NameUtilitiesSource: Morningstar Direct as of Dec. 31, 2014. Sector allocations are subject to change without notice.7Eugene F. Fama and Kenneth R. French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, vol. 33, no. 1, 1993, 3–56.For Institutional Use Only. Not for Further Distribution. 5

SCHWAB CENTER FOR FINANCIAL RESEARCH Journal of Investment ResearchExhibit 5Market capitalization and style comparison (%)Market alueCoreGrowthSchwab Fundamental U.S. LargeCompany Index Fund (SFLNX)47.4733.6516.881.980.0349.3933.3417.28DFA US Core Equity 1 Portfolio I t Trust Large Cap Core AlphaDEXFund eim S&P 500 Equal Weight rShares FTSE RAFI US 1000Portfolio ares S&P 500 Low VolatilityPortfolio Tree LargeCap Dividend ell 1000 Index44.8833.1619.952.000.0233.7032.0434.26S&P 500 Index51.2836.4012.270.060.0034.6232.5332.85Source: Morningstar Direct. Data as of Dec. 31, 2014. Data is subject to change without notice. Market capitalization may vary without notice. Market-capitalizationbreakpoints, determined by Morningstar Direct: Mega cap, over 72.8 billion; Large cap, between 17.0 billion and 72.8 billion; Mid cap, between 3.7 billion and 17.0billion; Small cap, between 1.2 billion and 3.7 billion.the outperformance tendency: Is it caused bymarket efficiency or inefficiency? On the efficiencyside of the debate, the outperformance maygenerally be explained by the excess risk thatvalue and small-cap stocks face as a result oftheir higher cost of capital and greater businessrisk. On the inefficiency side, the outperformancecould be explained by market participantsmispricing the value of these companies, whichprovides excess return in the long run as thevalue adjusts.The Guggenheim S&P 500 Equal Weight strategyhas the highest allocation to mid-cap stocks andthe lowest allocation to mega-cap stocks. Equalweight strategies, like the Guggenheim strategy,provide the same weight to every company in anindex. Equal-weight strategies will have a smallercapitalization than their market-cap equivalentsbecause of the weighting methodology.Exhibit 5 also provides a breakdown of allocationsacross value, core, and growth. The twoPowerShares strategies and the WisdomTreestrategy have the highest allocations to value(51.66%, 50.57%, and 51.42%, respectively),6 and the DFA strategy is the closest to a neutralweight between value and growth (34.67% versus32.47%). The underlying major market indexes—S&P 500 Index and Russell 1000 Index—are alsoclose to neutral weighting across value,core, and growth.The information contained in Exhibits 4 and 5helps explain the differences in returns overtime. The portfolio characteristics may vary,but the difference in the underlying index andconstruction methodologies likely means thatthe differences will persist. Advisors shouldseek to better understand the weightingmethodology, which ultimately leads todifferences in the underlying portfolio. Thesector allocations, market capitalization, andvalue-growth bias will culminate in differentreturns and risks over time.Implementing strategic beta strategiesSchwab believes in the value of strategic betastrategies. As noted above, however, we see ahigh degree of variability across the types ofstrategies. Advisors should understand theweighting methodologies, underlying indexes,For Institutional Use Only. Not for Further Distribution.

Strategic beta strategies: An evaluation of different approachessector allocations, market capitalizations, andvalue-growth tilts, and should keep in mind thatportfolio characteristics will change over time.The Schwab Center for Financial Research hasdone extensive research on Fundamental Indexstrategies. Schwab believes that fundamentalstrategies may serve as a nice complement toboth market-cap and active management options(see An evolutionary approach to portfolioconstruction).As shown in Exhibit 6, there are four key leversthat can help determine an appropriate weightingamong these types of strategies: tracking error,loss aversion, alpha, and cost.Market cap provides little or no tracking error(fees could provide a small drag), no downsideprotection, and no alpha. Fundamentalstrategies have historically delivered alpha andhave a relatively high tracking error comparedwith market cap. Active managers seek todeliver alpha and may provide some downsideprotection. Although there are merits to indexbased strategies, such strategies are unable todeviate from their rules-based discipline. Activemanagers have greater flexibility and can adaptto changing market dynamics.Depending on investors’ sensitivity to the leversabove, they could choose to overweight orunderweight each of these strategies. Fundamental: Investors who are seeking alphaand have no concerns about tracking error maychoose to overweight fundamental strategies. Active: Investors who are concerned aboutthe ever-changing market environment andwant an active manager to be able to altertheir strategy over time may want to considera larger allocation to active management.Advisors should seek to identify managers thathave historically delivered better downsidecapture ratios.ConclusionIn recent years, strategic beta strategies haveevolved significantly, providing a range ofstrategies that offer different return and riskcharacteristics. These strategies provide differentways of accessing the various market segments.Strategic beta strategies, or smart betastrategies, represent a sophisticated way ofbuilding index-based portfolios. These solutionsapply logic and academic research to the weightingmethodologies used in index construction, leadingto a different client experience.Caveat emptor: Let the buyer beware. Not allstrategic beta strategies are created equal,and there are important differences among thestrategies available in the market. Before investing,advisors and individual investors should gain anunderstanding of the weighting methodology andany tilts or biases that may be introduced. Market cap: Investors who seek a costeffective way of owning the market and wantto limit tracking error may want to consider anoverweight to market-cap strategies.Exhibit 6Portfolio construction leversKey leverMarket capFundamentalActiveTracking errorLittle or no tracking errorHigher tracking errorVaries by managerLoss aversionNo downside protectionNo downside protectionMay provide a level of downside protectionAlphaNoPotential alphaVariesCostLowest costLow costVaries by manager and vehicleFor Institutional Use Only. Not for Further Distribution. 7

SCHWAB CENTER FOR FINANCIAL RESEARCH Journal of Investment ResearchAppendix8 NameMethodologySchwabFundamentalU.S. LargeCompany(SFLNX andFNDX)The Schwab Fundamental U.S. Large Company Index Mutual Fund and the Schwab FundamentalU.S. Large Company ETF seek investment results that correspond generally (before fees andexpenses) to the total return of the Russell Fundamental U.S. Large Company Index. The mutualfund and ETF will typically invest in stocks that are included in the index. The index measures theperformance of the large company size segment by fundamental overall company scores, whichare created using as the universe the companies in the Russell 3000 Index. The RussellFundamental methodology utilizes three fundamental metrics of company scale and success:retained operating cash flow, adjusted sales, and dividends plus buybacks. Influence: Rob Arnottand Research Affiliates.DFA US CoreEquity 1 Portfolio I(DFEOX)The portfolio seeks to purchase a broad and diverse group of securities of U.S. companieswith an increased exposure to small-cap companies and those Dimensional considers valuecompanies relative to the U.S. market universe. The universe comprises U.S. operatingcompanies listed on the New York Stock Exchange, Nasdaq Global Market , or such othersecurities exchanges deemed appropriate by Dimensional. Increased exposure to small andvalue companies may be achieved by decreasing the allocation of the portfolio’s assets inlarge growth companies relative to their weight in the U.S. universe. Securities are consideredvalue stocks primarily because a company’s shares have a high book value in relation to theirmarket value (BtM). In assessing value, factors such as price to cash flow or price to earningsratios may be considered, as well as economic conditions and developments in the issuer’sindustry. The criteria for assessing value are subject to change from time to time. Influence:Eugene Fama and Ken French.First Trust LargeCap CoreAlphaDEX (FEX)Ranks the stocks from the S&P 500 Index on growth factors including three-, six-, and 12-monthprice appreciation, sales to price, and one-year sales growth, and separately on value factorsincluding book value to price, cash flow to price, and return on assets. The selected stocks aredivided into quintiles based on their rankings, and the top-ranked quintiles receive a higher weightwithin the index. The stocks are equally weighted within each quintile. The index is reconstitutedand rebalanced quarterly.GuggenheimS&P 500 EqualWeight (RSP)Guggenheim S&P 500 Equal Weight ETF (RSP) seeks to provide investment results thatcorrespond to the daily performance of the S&P 500 Equal Weight Index (SPXEW), an indexdeveloped by Standard & Poor’s in collaboration with Guggenheim Investments. In the S&P 500Equal Weight Index, each of the stocks that make up the index is “equally weighted.” To maintaincomposition, the S&P 500 Equal Weight Index rebalances quarterly.PowerSharesFTSE RAFI US1000 (PRF)The PowerShares FTSE RAFI US 1000 Portfolio is based on the FTSE RAFI 1000 Index. The fundwill normally invest at least 90% of its total assets in common stocks that the index comprises.The index is designed to track the performance of the largest U.S. equities, selected based onthe following four fundamental measures of firm size: book value, cash flow, sales, anddividends. The 1,000 equities with the highest fundamental strength are weighted by theirfundamental scores. The fund and the index are reconstituted annually. Influence: Rob Arnottand Research Affiliates.PowerSharesS&P 500 Low Volatility(SPLV)The PowerShares S&P 500 Low Volatility Portfolio is based on the S&P 500 Low Volatility Index.The fund will invest at least 90% of its total assets in common stocks that the index comprises.The index is compiled, maintained, and calculated by Standard & Poor’s and consists of the 100stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months.Volatility is a statistical measurement of the magnitude of up and down asset price fluctuationsover time. The fund and the index are rebalanced and reconstituted quarterly in February, May,August, and November.WisdomTreeLargeCapDividend (DLN)WisdomTree LargeCap Dividend Fund seeks investment results that closely correspond to theprice and yield performance, before fees and expenses, of the WisdomTree LargeCap DividendIndex. The WisdomTree LargeCap Dividend Index is a fundamentally weighted index that measuresthe performance of the large-capitalization segment of the U.S. dividend-paying market. The indexis composed of the 300 largest companies ranked by market capitalization from the WisdomTreeDividend Index. The index is dividend weighted annually to reflect the proportionate share of theaggregate cash dividends each component is projected to pay in the coming year, based on themost recently declared dividend per share. Influence: Jeremy Siegel.For Institutional Use Only. Not for Further Distribution.

Strategic beta strategies: An evaluation of different approachesGlossary of termsAlpha. A performance measure on a risk-adjustedbasis. Alpha takes the volatility (risk) of a mutualfund, or other type of investment, and comparesits risk-adjusted performance with a benchmarkindex. The excess return of the fund relative to thereturn of the benchmark index is a fund’s alpha.Beta. A measure of the volatility, or systematicrisk, of a security or a portfolio in comparisonwith the market as a whole. Beta is used inthe capital asset pricing model (CAPM), whichcalculates the expected return of an asset basedon its beta and expected market returns.Correlation. Correlation measures therelationship and movement of two or moresecurities, ranging between -1 and 1. Perfectpositive correlation (a correlation of 1) impliesthat as one security moves, either up or down,the other security will move in lockstep in thesame direction. Alternatively, perfect negativecorrelation means that if one security movesin either direction, the security that is perfectlynegatively correlated will move in the oppositedirection. If the correlation is 0, the movementsof the securities are said to have no correlation;they are completely random.Fundamentally weighted index. A type of equityindex in which components are chosen basedon fundamental criteria as opposed to marketcapitalization. Fundamentally weighted indexesmay be based on fundamental metrics suchas sales, cash flow, and dividends. Proponentsof these indexes claim that they are a moreaccurate aggregate measure of the marketbecause market-capitalization figures tend tooverweight companies that are richly valued whileunderweighting companies with low valuations.Fundamentally weighted indexes are sometimesreferred to as strategic beta, alternative beta, orsmart beta.For Institutional Use Only. Not for Further Distribution. Market-cap weighting. Most of the broadly usedmarket indexes today are “cap-weighted” indexes,such as the S&P 500, Russell, and MSCI indexes.In a cap-weighted index, large price moves in thelargest components can have a dramatic effecton the value of the index. Some investors feel thatthis overweighting toward the larger companiesgives a distorted view of the market.Sharpe ratio. A ratio developed by Nobel laureateWilliam F. Sharpe to measure risk-adjustedperformance. The Sharpe ratio measures theexcess return (or risk premium) per unit ofdeviation (risk) in an investment. The Sharperatio characterizes how well the return of anasset compensates the investor for the risk taken.When comparing two assets versus a commonbenchmark, the one with a higher Sharpe ratioprovides better return for the same risk (or,equivalently, the same return for lower risk).Standard deviation. Standard deviation is astatistical measurement that sheds light onhistorical volatility. For example, a volatileportfolio will have a higher standard deviationthan a less volatile portfolio. A large dispersiontells us how much the return on the fund isdeviating from the expected normal returns.Strategic beta. Also known as alternative betaand smart beta. Strategic beta strategies attemptto deliver a better risk and return trade-off thanconventional market-cap-weighted indexesby using alternative weighting schemes basedon measures such as volatility. Strategic betastrategies include a range of alternative weightingmethods: fundamentally weighted, equalweighting, minimum variance, and low volatility,among others.9

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Index, Russell 1000 Index, Russell 2000 Index, MSCI EAFE Index) are market-cap weighted, . the use of the Fundamental Index methodolog