Delving Deeper Into Strategic-Beta ETFs

Despite all the consternation and controversy over the terminology, smart or strategic-beta exchange traded funds are one of the fastest-growing segments of the ETF industry.

Strategic-beta ETFs, which funds employing various weighting methodologies from dividends to equal-weighting to factor-based funds, continue outpacing the ETF industry's already impressive growth. At the end of the second quarter, there were 844 strategic-beta ETFs, with collective assets under management of approximately $497 billion worldwide, according to Morningstar.

There is reason to believe the growth of strategic beta ETFs is still in the early innings because advisors and institutional are continuing to boost usage of such funds. According to FTSE Russells first U.S. retail financial advisor market survey (Smart Beta: 2015 survey findings from U.S. financial advisors), 68 percent of financial advisors polled are using smart beta ETFs and 70 percent are usingmultiple strategic-beta approaches.

Year-to-date, three of the top 10 asset-gathering ETFs are currency-hedged funds, a group that can be classified in the strategic-beta realm. Those ETFs are the WisdomTree Europe Hedged Equity Fund (NYSE:HEDJ), Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSE:DBEF) and the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ).

"As new products have continued to roll off asset managers' assembly lines, their sales and marketing departments have been working tirelessly to position these new models within an increasingly competitive field. The result has been a ratcheting up of the level of complexity of the indexes that form the raw stuff of these benchmark-based investment products and, in some cases, a growing disparity between how they are pitched by their sponsors and the actual investment results they produce, notes Morningstar.

Speaking of new, sophisticated ETFs, several of this year's most successful rookie ETFs are strategic-beta products, including the WisdomTree Europe Hedged SmallCap Equity Fund (NYSE:EUSC) and the PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSE:XRLV).

A frequent criticism of strategic-beta ETFs is that these funds often sport higher fees than their traditional cap-weighted counterparts. While the average fee differential between a cap-weighted ETF and a strategic beta fund is not jaw-dropping, it adds up over time and there are plenty of examples of prosaic broad market ETFs with annual fees of 0.1 percent or less while it is not hard to find smart-beta products with annual expense ratios in the 0.7 percent (or higher) range.

There is good news on the strategic-beta fee front. As Morningstar notes, increased competition in the space is likely to pressure fees and that is good for investors. It's already happening. On Wednesday, Goldman Sachs introduced its second ETF this month, the Goldman Sachs ActiveBeta Emerging Markets Equity ETF (NYSE:GEM). That ETF is priced 34 percent lower than the most liquid Emerging Market Equity ETF by volume, and more than 22 percent lower than the Morningstar Diversified Emerging Markets category Strategic Beta average, according to Goldman.

Goldman's first ETF, also a strategic-beta offering, the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (NYSE:GSLC), costs just 0.09 percent per year, putting it in direct fee competition with popular cap-weighted funds issued by Vanguard.

"An increasingly crowded and competitive landscape will also put pressure on fees. We have already seen instances of aggressive fee reductions for strategic-beta ETPs. We anticipate that cost-competition in this space will become more prominent in the years to come, said Morningstar.

Home to a combined $51.1 billion in assets under management, the iShares Russell 1000 Growth ETF (NYSE:IWF) and the iShares Russell 1000 Value ETF (NYSE:IWD) are the two largest (and oldest) strategic beta ETFs trading in the US.