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.

Financial Planning - - CONTENT - By Bryan Borzykowski

Stud­ies show smart beta ETFS beat­ing bench­marks more than funds with hu­man driv­ers, but some ad­vis­ers doubt they can do it across the board.


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.


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.”


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.

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