Smart Beta vs. Active Managers
Smart beta ETFS beat benchmarks more than funds with human drivers, studies show, but some advisers doubt they can do it across the board.
Studies show smart beta ETFS beating benchmarks more than funds with human drivers, but some advisers doubt they can do it across the board.
SPENCER BETTS HAS ALWAYS BEEN AN ACTIVE management guy.
He didn’t like benchmark-hugging ETFS because passive products hold the bad companies with the good. If a big player on the S&P 500 were to sink and drag down the index, then the ETF would fall in tandem. Stock picking, he said, made more sense.
About two years ago, Betts started hearing about smart beta products — ETFS that go slightly beyond mere indexing to incorporate investment characteristics like value, momentum and high yield and are designed to beat a benchmark. His stance on passive investments began to soften.
“ETFS have gotten more interesting,” concedes Betts, a Lexington, Massachusetts-based adviser with Bickling Financial Services. “We used to have a ‘Dogs of the Dow’ mutual fund, but now we can get an ETF and pay 20 basis points instead of 65.”
About 10% of his firm’s $200 million in assets under management are in smart beta ETFS, but he says he could envision a more even split between active management and
ETFS in the future.
Until recently, the choice between exchange-traded funds and active management was clear. Advisers who wanted to hold inexpensive index-like products would buy ETFS, while those who preferred stock-picking managers would buy mutual funds and pay higher fees.
With the advent of benchmark-beating ETFS, the lines between active and passive have blurred. That has advisers wondering what’s better for their clients — smart beta securities or actively managed funds?
If you look at the data, factor-based investing does exceed its benchmark more often than mutual funds.
According to ETF Trends, between December 2013 and April 2017, only 19% of active managers outperformed their respective style benchmarks compared with 40% of smart beta ETFS.
‘BEST INVESTMENT EVER’
In historical research from Bloomberg, Peter Lynch’s legendary Fidelity Magellan Fund was pitted against a quantitative value strategy that invested in the cheapest 30% of U.S. stocks by price-to-book ratio and weighted them equally across the fund.
Between May 1977 and May 1990, covering the years that Lynch managed his fund, the Magellan portfolio returned 29.1% annually with a 21.1% standard deviation. The smart beta strategy, meanwhile, returned 23% annually with a 17% standard deviation. One problem with much of the smart
beta data is that many of these funds were created only recently, so the historical data is sparse.
The lack of a track record is why Betts isn’t more heavily invested in these products. There are back-tested numbers, but “every back test shows that this is the best investment ever,” he says.
Still, these funds have taken off — assets under management rose 33% to $560 billion in globally listed smart beta products in February — largely because they come cheap. For instance, the most popular smart beta fund by AUM, the ishares Russell 1000 Value ETF, has a 0.2% expense ratio. The largest value-focused mutual fund, American Funds Washington Mutual, has an expense ratio of 0.58%.
“Cost is the primary factor,” says Jacob Wolkowitz, a managing director of the Minneapolis-based Accredited Investors Wealth Management.
“If you want a stock picker who is valuation conscious and can pay 0.09% for that versus 0.25%, then why wouldn’t you go with the cheaper option? You can get the same returns or better from factor investing, but at a lower cost.”
COMBINATION OF PRODUCTS
Despite the fee gap — ETFS’ tax-efficient structure gives it another advantage over mutual funds — many advisers continue to embrace active management, including Wolkowitz, whose firm has about 20% of its assets in smart beta strategies, 25% in more traditional passive ETFS and the rest in actively managed funds.
His company, which oversees $1.7 billion from high-net-worth clients, started using smart beta strategies in 2006 and has replaced most of its United States-focused mutual funds with factor ETFS. But its international investments are mainly overseen by fund managers.
In the United States, active managers do not add as much value, he says, noting that most have been able to generate only minuscule returns or have even produced negative returns.
Wolkowitz readily acknowledges his unfamiliarity with international markets and points to the fact that many of the products do not yet have a track record. With that, he says he would rather entrust his client’s assets to real people.
“We have a better understanding of corporate governance in the U.S., and we know that what’s worked in the past is likely to work in the future,” he says. “Emerging markets are still figuring things out and value companies may not recover as consistently as they have in the U.S.”
Ben Johnson, Morningstar’s director of global ETF research, says most advisers use a combination of smart beta and active management, in part because smart beta ETFS cannot adjust their asset allocation in a pinch in the way that fund managers can.
“These are active bets employed in a passive, rules-based systematic fashion,” he says. “Once the playbook has been written, no one’s going to call an audible.”
Different advisers also have different styles. Some might use a manager with a strong track record and employ smart beta only to fill in some gaps.
Others, like Wolkowitz, might want to use managers in areas in which the adviser is less comfortable.
“There can be a case that these investments can be used together, and that’s the reality of what we’re seeing,” Johnson says. “If you look at the makeup of a client’s portfolio, they’re using all things active, passive and everything in between.”
That is the approach that Betts takes. He might be an ETF convert, but he still likes his active managers. “I’m happy with the active beta stuff because I agree with it,” he says. “But they complement each other. We believe in long-term asset allocation so we just want to have the clients in the right buckets over time.”
“These are active bets employed in a passive, rules-based systematic fashion. Once the playbook has been written, no one’s going to call an audible,” says Ben Johnson of Morningstar.
Bryan Borzykowski is a freelance financial writer and editor based in Toronto. He has written three personal finance books and appears regularly on Canada’s CTV News. Follow him on Twitter at @bborzyko.