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Either/or, or the best of both? The promise of Smart Beta

Friday 6th March 2015

By Mike Abbott, Head of Wealth at Sable Group
2014 was a bad year for active managers: according to a recent article in the FT it was the worst on record. The myth of the self-proclaimed genius investor has taken a battering, and with it, the view that experience always equates to success. In reality, active managers rarely beat the markets in the long run, and on the off-chance that they do, their high fees tend to outweigh any real benefits.
Of course, the end of one paradigm gives rise to a new vacancy, and people are already on the lookout for an alternative. Only this week, we learned that if they had opted instead for passive funds, last year’s investors could have saved £800 million. Is this going to save us all, or do we risk stumbling into the same trap from the opposite direction?
As mentioned, the problem with active management is that the data suggests there’s a basic inability to beat the market consistently over time. The “Efficient Market Hypothesis” does a good job of explaining this: above-average performance – i.e. above the 50th percentile – requires you to consistently outsmart your peers, but outperformance has a nasty habit of regressing to the mean. In other fields, common sense suggests that you’ll get better over time, but – as Taylor and Pastor observed in Scale and Skill in Active Management - finance isn’t like other fields. Ironically, the size of a manager’s fund hampers their attempts at outperforming the competition – sooner or later, they end up as victims of their own success. Once the fund starts to see outflows then outperformance becomes nearly impossible. In addition, the information revolution we’re living through means the active managers’ peers are getting better educated and better informed every day. So whatever information advantage he believes he has is eroded on a daily basis. This is why much of the active management industry is often accused of running closet index funds while charging active management fees.
This newfound awareness of our limitations is driving a surge in the popularity of “passive investment”. Passive investors eschew the practice of hunting for those elusive winning stocks, instead choosing to “buy the market”, investing in a mathematically-calculated sample that reflects the market. Because passive portfolios fluctuate with their aligned indexes, they have some clear advantages over those managed actively – most obviously, they’re considerably cheaper. This explains the recent boom in this kind of investment: index-linked equity funds in the US attracted $1.7 trillion by the end of 2013 – $114 billion more than the year before.
Nonetheless, passivity provides no panacea. Someone needs to identify the target index and decide how to replicate it, but replicating an index in physical form is tough – and risks creating tracking errors. Accordingly, most tracker funds with physical replication track large, developed market indices where liquidity is assured. These logical constraints make passive funds more available in some sectors, regions and asset classes than others. Fixed income is a particular area of concern. Of course, markets are global and know no frontiers – but it’s very hard to achieve global exposure without neglecting small caps or emerging markets.
Is there another alternative? The “active” versus “passive” debate has rumbled on for so long that you’d be forgiven for believing that they’re the only investment strategies worth pursuing. However, academics have found a way for investors to have their cake and eat it, combining the best of both contending strategies while eliminating many of their downsides. These theorists have called for an approach that focuses on investing passively on a global scale, but tilting the portfolio toward known elements of higher expected return – this creates a passive strategy with an active overlay.
This approach relies on the notions of two Nobel Prize winning finance academics, Fama and French. They thought that there are two dimensions of known outperformance: the ‘small cap premium’ and the ‘value premium’. Many now accept a third dimension (identified by Novy-Marx) known as the ‘gross profitability premium’. There are other identified elements (such as momentum) but debate continues on how tradable they are. The ideal fund, then, tracks these known tradable elements. This is where things get tough for managers, because they have to find a structure that accommodates these elements – without incurring a cost that negates their benefits.
These strategic choices can be confusing. Should investors go active, passive, or opt for some kind of happy medium? Everybody wants to be the maverick genius whose brilliant choices see off the competition. But a seductive myth is still a myth, and if you’re taken in by it, you’re needlessly exposing your money to the wrong side of the mean. Whatever you decide, these are questions you can’t afford to ignore.

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Editorial Contact Details - Conor Shilling
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