Back when you were playing on the playground in grade school, do you ever recall the teacher asking all kids to “get along” and “play nicely together?” Well, this same way of thinking applies to the world of equity investing. I believe it’s possible that the three equity investment approaches — active, passive, and smart beta — can “get along” and have a place in providing value to an investor’s portfolio. Moreover, it’s all about creating a more efficient portfolio where all three approaches can contribute. Toward that end, let’s define some pros and cons to each approach.
However, before all three approaches of investing can earn an allocation claim in an investor’s portfolio and play nicely together, a few things need to happen in the industry.
Yes, it has been a tough three-to-five years for United States large-cap managers because most active managers failed to beat their indexes after management fees. Consequently there’s been a significant shift from active to passive investing. Now, equity-risk premia and factor-based style investing is coming under the more recognized moniker of “smart beta,” further challenging the actively managed assets. Fees are also squeezing investors’ profit margins.
This begs the question: is active management dead? Absolutely not! Moreover, there will be a second revival of active management with some necessary changes. Here are a few other questions to consider:
What part of your returns can be replicated by stylistic betas that I can buy cheaply, say 20 basis points
What part of your returns cannot be explained by this cheap beta?
I believe that active managers who provide more stylistic beta returns but charge active fees for alpha will have to reduce their fees or cease to exist because of lower-cost alternatives. The further fee reduction will force industry consolidation and will also define who the true fundamental alpha providers are. These active managers will command a premium for active fees.
After a period of lower fees for active managers, they are likely to beat the passive indexes and true alpha will come to fruition. In this environment, style betas such as value, momentum, and quality will thrive. As an active manager, you have to provide uncorrelated alpha to these style betas or simply be better than your competitors within your styles and offer something more within those styles. Also note that this movement has already started. For example, we’re already seeing investors asking for highly concentrated, highly active portfolios. However, beware of the pitfalls: a portfolio could be highly concentrated but you could be still getting all stylistic beta, not alpha! In addition, we have observed an acceleration of fund closings and deceleration of fund openings since the financial crisis (see chart below).
Let me also address the smart beta movement. I believe smart beta will be a bigger challenge to passive management and will start to take market share from passive as the fees for smart beta products continue to decline. After all, research shows that passive index funds are not efficient in “Markowitz efficiency” sense, which means that there is always a portfolio that provides a better risk/return trade off than passive indexes. In other words, an investor can get a better Sharpe ratio or return per amount of risk, than a typical passive index fund can provide.
If this is the case, however, why do active managers underperform? After all, search for active “alpha” and active management has the same objective of achieving superior Sharpe ratios than passive index funds. The answer is not in achieving high Sharpe ratios but achieving superior Sharpe ratios net of management fees. That’s why I believe, declining fees in the smart beta products will give a challenge to passive investing in index funds. After all, the main benefit of smart beta is to provide better diversification of risk premia and style betas than an investor gets in a capitalization-weighted passive index fund. With lower fees, it’s possible to combine different stylistic betas (equity risk premium such as value, quality, low volatility, momentum, size, carry) in a much more efficient and diversified way than a capitalization-weighted index dictates that the investor should hold.
To summarize, it‘s all about investment efficiency, “net” of costs. Let’s face it, some passive investment is still needed to anchor portfolios to lowest possible cost even though you know that it’s not efficient. Then it’s ok to “pay–up” for alpha uncorrelated to style betas to earn excess returns based on forward-looking judgment of active managers. Finally, completing the portfolio with diversified stylistic betas with low cost to achieve desired efficiency, such as higher returns, lower risk and/or downside protection, based on the risk tolerance of the investor. This “building blocks” portfolio approach can also be customized for individuals, even using “robo” advisors. The net result is investors having greater flexibility to design portfolios that are more efficient to achieve their risk/return objective, net of fees.
Smart beta has turned investment efficiency argument into a continuum rather than the bi-polar world of active versus passive. Enter the age of personalization where one no longer has to fit the objective to the strategy products, but can rather fit the strategy products to the objective. We will all win after the industry figures out how all these solutions ‘get along’ like when we were young on the playground.
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