The Middle Ground

June 29, 2014


The active-passive debate began when Jack Bogle launched the first S&P 500 index fund in the late 1970s and opened index investing to everyone. A decade later, Bill Sharpe explained that index funds’ lower fees meant indexing would outperform the average active manager.1 More recently, S&P Dow Jones Indices’ SPIVA reports2 provided empirical data demonstrating that indexes typically outperformed two out of three active mutual funds over a period of a year or more. Securities analysts recast the debate in terms of the capital asset pricing model. Alpha is stock-specific return and represents active management; beta is market return and is measured by a market index. Stock pickers focus on reasons their alpha is positive; indexers track the market.

The Small-Cap Value Mystery
The debate has changed and a middle ground is now occupied by alternative beta, a factor-based approach. Just as with active stock pickers and indexers, arguments about alternative beta and factors are based on economic and financial theory, while success will depend on performance after fees and expenses. The initial spark for alternative beta seems to have been the thought that one could beat indexing if one could only underweight stocks that lag the market and overweight those that do better. While this sounds like wishful thinking, the split between growth and value analyzed by Gene Fama and Ken French and others suggests how this can be done: If given enough time, value stocks tend to outperform and growth stocks tend to underperform. Further, growth stocks tend to be large while value stocks tend to be small. If an index drops market-cap weights for an approach that recognizes the relative size of growth and value, improved performance should generally result. There are many possible approaches, the simplest of which is equal weighting. However, virtually all alternative beta approaches abandon market-cap weighting in favor of a metric that focuses on value; some add other factors as well.

While there is almost universal agreement that value stocks usually outperform in the long run, there is almost no agreement on why. One argument is that the extra return can only be had by accepting additional risk, that investing doesn’t offer any free lunches. The difficulty is that the two most widely cited risk measures—volatility of returns and beta—tend to be lower with value than with growth. The alternative suggestion is that investors may be irrational in their stock selection: They ignore the evidence about value, and seek growth stocks’ higher P/E ratios as confirmation they chose the best stocks. Price or cost may explain the value factor—value stocks look cheap, and people often mistake price for a measure of value.

Alternative beta funds are marketed as new and improved index funds, but tend to have higher management fees than simple index funds. However, management fees are only part of the cost story. Other expenses are also likely to be larger with alternative beta funds than plain-vanilla index funds. These include trading costs, rebalancing, adding or deleting stocks, turnover and scale economies. Results of index funds tracking widely followed capitalization-weighted indexes like the S&P 500 suggest why alternative beta and actively managed funds may be at a cost disadvantage. The three largest S&P 500-tracking ETFs have expense ratios of 5 to almost 10 basis points. As small as these seem, in 2013, one of these funds beat the S&P 500 after fees by a basis point and a second recovered part of the fee through performance.3



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