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September 19, 2016

Active, Passive or Smart Beta: Who’s Winning?

by John Mitchem.

As markets have grown steadily more efficient in recent decades, it has become more difficult – and expensive – for fund managers to deliver excess returns relative to benchmarks, or “alpha”.

Even though investment fund flows into passive strategies have accelerated steadily in recent years, active strategies still account for fully 70% of the $15 trillion in U.S. mutual funds. But active and passive are not the only choices. We are also seeing a booming trade in “smart beta” – an imprecisely defined cluster of rules-based strategies that avoid traditional cap-weighted index construction and seek profits amid market factors and inefficiencies. Watch the video debate from the Lipper Alpha Forum or read an editorial summary below.

The “Beginning of the End” for Active Management?

  • Within indexing the lowest cost quartile of index funds is gathering the most inflows. While active has been “bleeding” flows to indexing, the lowest cost quartile of active funds has been gaining flows. Approximately 70% of the flows from active funds to indexed funds have departed from only five high-cost active fund complexes.
  • There will always be a place for active management. Different investors have different needs: appetite for return; risk avoidance; or environmental, social, and governance (ESG) issues. High-quality active management, if delivered at a low cost, can consistently beat index investment.
  • Some 70% of active manager performance can be attributed to factor performance. Performance associated with these factors can definitely be achieved through indexing.
  • Smart-beta strategies are being delivered through index form, in large measure because exchange-traded funds (ETFs) are easy to create from a regulatory perspective. This raises a subjective question as to the definition of an index. Factor strategies can be seen as an index or simply as a rules-based strategy.

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Is there an industry movement toward lower fees?

  • There is a clear industry trend toward fee compression. Classic generic strategies–such as factor strategies–should be priced competitively. But unique strategies are valuable and should command higher fees. The challenge is to distinguish between generic and unique strategies–factors are obvious, skill is less so.
  • The industry attracts a very high skill set from managers who can profit substantially from adding a basis point or two of return. This confronts investors with the “paradox of skill”–a concept created by industry pioneer Charles D. Ellis, founder of Greenwich Associates. The concept holds that, since greater numbers of gifted investment professionals have entered the asset management marketplace, it has become more difficult for active managers to profit from others’ errors and thereby beat market averages.

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How does market timing impact index and active allocations?

  • Some types of regimes favor different types of management. Many pundits believe that dispersion (reduced market correlation) favors active management or – at the very least – value over growth. Momentum is a very powerful factor–for example, momentum funds were hurt badly during the turndown of 2008 and 2009. Macroeconomic factors are an important signal in this regard.
  • In one market active management may be crushing high yield, while in other markets indexing might excel. Investors have to be careful that they are comparing apples to apples when they consider the timing of markets.

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How does smart beta fit in amid other strategies?

  • Smart beta is effectively a hybrid of passive (systematic, transparent, low-fee) and active (using unique perspectives and research to determine asset allocation). There are certain factors–value, momentum, quality, carry–that can be captured systematically and that can add diversification to portfolios.
  • Investors who migrate to smart beta tend to come from passive strategies built around cap-weighted indices that overweight large-caps over small-caps. Many investors want to make a “size bet” because they want to avoid concentration risk associated with large-caps or they see more value in smaller-caps.
  • All market strategies are subject to cyclical valuations and to time-varying premiums. At any given time the market may prioritize value, growth, small-caps, or large-caps. Timing these sentiments is difficult, but investors can achieve diversification of market cap, style, geographies, and asset classes…but also across factors. Smart beta can play an important role here.
  • Investors can avoid market-timing risk by exploiting uncorrelated and even negative correlations, as is the case between valuation and momentum. Asset classes and factors are all cyclical in nature.

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Lipper Alpha Forum, New York, March 22, 2016.

Panelists:

  • Jeff Benjamin, Senior Columnist, Investment News (Moderator, far left)
  • Tim Gaumer, Global Director, Fundamental Research, Thomson Reuters (center left)
  • Mark Carver, Vice President, AQR Capital Management (center right)
  • Frances Kinniry, Principal, Vanguard Investment Strategy Group (far right)

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