The active versus passive debate in the investment world is as old as time. For as long as people have been investing money, there have been those that think they can do it better than others, and want to charge a premium for doing it.
However, before we get into the debate from a different angle, let us classify the two approaches:
Active investing is where a manager or investor uses a methodology for his security selection in order to generate investment returns that are better than the market average.
An active investor believes he has some insight that will lead to excessive returns.
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Passive investing is where an investor does not believe or have any superior insight and therefore simply chooses to invest in the market as a whole, often via low-cost exchange-traded products. The Top40 tracker is a great example of a passive investment for South African investors.
Here investors get exposure to the top 40 shares on the JSE via a low-cost exchange-traded product. The benefit of this is that the investor is not trying to work out which of the shares are the ones worth buying and is simply happy to hold a basket of local-listed equities.
Active investors are in search of alpha, which is the return generated over and above that given by the market in a period. The market, on the other hand, gives investors what is known as beta.
Beta is simply the return of the market that is made up of every listed share. Active managers try to outsmart the market, while passive investors simply try to capture what the market offers in the form of returns.
It all seems fairly logical. You may also be thinking at this point that active managers with all their education, insight and analyst teams have the ability to identify good investment opportunities and avoid the poor ones.
The truth is that active managers, on average, give you the market return, because for every winner there must be a loser.
Moreover, the reality is that you do not get the average (or the market return) because you often pay excessive fees for the active manager to give you the average market return.
In almost any decade, the number of active-management strategies that outperform traditional passive investments is around 15% to 25% after costs.
To frame it another way, between 75% and 85% of the time, traditional passive strategies outperform active managers. If you want a high probability of achieving a better return, I would suggest passive investing over active.
I will avoid going further into the active versus passive debate, since another opinion from either side of the fence is not going to get us anywhere. So instead, let’s discuss the best solution for both parties: Smart beta.
What is Smart beta?
The term ‘smart beta’ (or ‘alternative indexation’) means very little to most, so let’s unpack it a little. If you were to invest in all the shares on the market in the same ratio, then your return will be that of the market, and you would have achieved a beta return.
The next question is: How is the market made up? Essentially, shares are weighted by market capitalisation. This means that the company with the highest value has the highest ranking.
It therefore means that, in a passive investment, the highly-valued company has the highest weighting, as these normal passive instruments have market capitalisation (market cap) weighting.
Market-cap weighted indexes have outperformed active managers consistently over time in all investment markets, after taxes and costs.
As I mentioned earlier, this is not enough to win the debate. The reason may be that the market-cap weighting methodology has some pretty clear downsides as far as economic theory goes. Most notably, it gives you the most exposure to stocks that are already highly valued.
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The best of both worlds
Modern finance tells us that there are a few clear and persistent risk premiums available to investors. Value and growth stocks are two examples of sub-sectors of the investment universe.
If one were to invest in either of these groups, you would tend to outperform the market as a whole. You therefore have beaten the market.
This, however, is not alpha, and is therefore not active management but rather smart beta. So, smart beta gives you a tested and systematic way to outperform your traditional passive investment options over the course of an investment cycle.
Logically, this also implies that you are outperforming at least 75% to 85% of active managers. It would appear as if you now have the ability to beat the market in an efficient and low cost manner without much effort.
This may be the ‘Holy Grail of investment’, as it blends the beauty of passive management (which is ease of use and low cost) with the screening process of many active managers.
Research Affiliates in the United States were early adopters of non-traditional passive strategies, creating a fundamentally weighted basket of stocks.
They would take the US stock market and screen it by five fundamental factors. The stocks that met the criteria and fulfilled all five factors were included in an index, which was weighted by these factors.
This methodology was trademarked and is available worldwide. Other alternative weighting strategies have come out of the woodwork.
We have simple strategies such as equal-weighted indices, which simply randomises the odds of which stocks will generate your return.
We also have value-weighted indices that weight stocks that satisfy value criteria, growth-weighted indices, momentum-weighted indices, volatility-weighted indices and even dividend-yield-weighted indices. The list grows longer almost daily.
The Holy Grail of investment
What has smart beta achieved? In my opinion, it combines all of the benefits of low-cost passive investing with the benefits of sound financial theory and screening. One could look at it as the perfect blend between active and passive investing.
Smart beta is available to all investors, both locally and globally. The depth of options in offshore markets is far more impressive than locally, but the move to ‘smart beta’ products is very noticeable among local product providers, either creating an offering locally, or partnering with an international partner to assist.
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Any readers who want access to smart beta products can chat to their financial advisors or stockbrokers.
Etfsa.co.za is a good place to look for all listed exchange-traded products in South Africa, however, one would probably want to get advice as to what exposure you are getting into, before investing.