As one gets older, it becomes clearer that while innovations are generally a good idea as they offer new choices, making these choices comes with challenges. Recent innovations in the investment space have had this exact result. New products such as smart beta and factor-based investing funds have blurred the lines between the traditional alternatives of passive and actively managed funds.
The purpose of this article is to provide more insights into these alternatives with the goal of empowering you to make better choices between them.
In the (bad?) old days, investors only faced the choice between different active managers or funds. They had to choose between different investment firms by trying to understand which one was more likely to produce consistent risk-adjusted performance when evaluated against a market-proxy benchmark (such as the JSE All Share Index, for example).
Then passive investment funds came along. Investors were offered the opportunity to buy the benchmark instead of some (potentially uncertain) pattern of returns from an active manager. Passive fund advocates said that their products offered an average return for a significantly lower fee than that charged by the actively managed funds. They also argued that, over long periods of time, the proportion of active managers that consistently outperformed the index was diminishingly small – particularly when fees were included in the calculation.
The fee reduction offered by passive investment funds is because the resources required to manage these funds is a fraction of those required by active managers. While managing to replicate an index return requires a great deal of skill, it does not require either the “army” of analysts or the (very well remunerated) portfolio managers typically required to actively manage an investment fund.
But what if you could have the (potential) benefits of the active strategies with the cost benefits of the passive investment approach? This is exactly what is offered by factor-based smart beta funds. These funds are based on the investment principles underlying most of the active managers, while being implemented in a way that mimics that of the passive funds.
What if you could have the (potential) benefits of the active strategies with the cost benefits of the passive investment approach?
The real innovation behind these funds came from insights provided in the academic world. Research showed that there were consistent, persistent anomalies which challenged the orthodoxy of the efficient market hypothesis. Developments in behavioural economics provided strong evidence for biases in people’s thinking processes which could lead to these anomalies. Combined with the recognition that there were limits to arbitrage meant that the traditional assumption of rationality underpinning the perspective that markets were efficient could be reasonably challenged.
These anomalies became known as “factors” and as the evidence mounted that they were likely to be real and persistent, investment managers realised that they could provide the basis for new investment products – the factor-based smart beta funds. These funds are like actively managed funds in that their holdings in individual stocks will vary significantly from those of the benchmark, but passive-like in their implementation – thus allowing them to be offered to investors at a significantly lower cost than their actively managed alternatives.
Smart beta funds can offer this because the logic behind their “active” deviations from the benchmark are effectively codified into a set of rules (not left to expensive portfolio managers’ judgement). In fact, these funds are exactly like passive funds in that they track an index, but the key difference is that their index is defined in terms of rules linked to some desirable feature of the underlying shares.
Value smart beta funds, for example, have greater exposure to “cheap” shares – while momentum smart beta funds hold more of shares that have done well in the past. These are captured in their index definitions. The challenge for investors is that in that these rules are not all the same across these funds. Like active managers they differ in terms what they believe they should hold, and how much they should hold of them.
Innovation brings opportunities, but also complexity. The recent introduction of factor-based smart beta funds is an excellent case in point. They offer the potential of the best of both worlds – actively managed portfolios that could potentially outperform a market benchmark, at a significantly lower cost. They have also added complexity as, unlike traditional passive funds, they are not all the same.
While they are cheaper than active managers, they are not as simple to purchase as passive investments. They are an exciting innovation, however, and investors are definitely better off by having them available. Their use, however, requires investors to do their homework before using them.