‘Smart Beta’ Is Next Fold To Active Vs. Passive

‘Smart beta’ almost surely means loss of more market share for active managers.

If you haven’t read Dave Nadig’s blog on the SPIVA report, do it now.

It’s a fair-minded and rigorous analysis of Standard & Poor’s’ twice-a-year comparison of active managers versus their respective benchmarks.

But if I’d fault Dave’s blog in one way, it’s that he’s perhaps a bit too polite about what such broad underperformance by active managers in the latest SPIVA report means.

Yes, he openly wonders how it is that active managers still have a job. Plenty still do have their jobs, but the truth is also that many don’t still have their jobs or, to put a finer point on it, some of the active management jobs that might exist today have been lost to indexing.

After all, 40 percent of institutional investment assets are now indexed and 15 percent of individual-investor money is indexed. Forty years ago, those numbers were zero, and indexing has gone from being scorned to being embraced by more and more investors.

It’s a slow grind, to be sure, given that the first index funds built around the S&P 500 Index came to market in the 1970s. But as the SPIVA data lay bare, active management isn’t generally worth the money.

Beyond SPIVA

Moreover, it’s worth noting that the SPIVA data are really no longer the state-of-the art way to convey the core message about active management.

What I mean is that the current SPIVA doesn’t mine data that reflects just how far indexing has come. I’m thinking of the plethora of factor-focused approaches to investing—call it “smart beta” concepts—such as value, momentum and quality that are now available in index wrappers.

The SPIVA data do reflect size-factor, distinguishing between large-, mid- and small-cap equities, but it doesn’t reflect the rest. To be fair, S&P plans to integrate other factors into its data mining, which is likely to make the case of employing at least some passive investing over active approaches even more persuasive than it already is.

Another important development in the past year or so has been the expansion of the idea at the core of SPIVA to the portfolio level. The verdict is even more damning.

Rick Ferri, the index investor who founded Portfolio Solutions, spearheaded an effort to mine data from the Center for Research in Security Prices that demonstrated how entire portfolios of index funds perform consistently better than entire portfolios built with active funds. ETF.com, with Ferri as a guest, hosted a webinar on the subject early this year.

Beta Is The New Alpha

To bring it back to SPIVA, it’s a very interesting valuable data series that has obvious value for investors.

That said, the world of investing has definitely changed in the past decade or so and the passive versus active debate has grown more nuanced. As an example, smart beta is often thought of as quasi-active. To be sure, smart beta is indexing in the sense that it is rules based, but it is poaching on territory once thought of as solely as active.

Think of it this way: Warren Buffett’s value-inflected investment style has rightly been regarded as genuine alpha. But these days, with viable value-focused indexing screens that are transparent and systematic, some of Buffett’s alpha of yesteryear has effectively become beta, as Larry Swedroe has argued in some of his columns here on ETF.com. For active managers, that must hurt.

By the way, Larry, the director of research for Buckingham’s BAM Alliance, will speak to this topic at ETF.com’s “Inside ETFs” conference next January in Hollywood, Florida. He is as unapologetic a passive investor as you’ll ever encounter, and will deliver a presentation he calls “The Incredible Shrinking Alpha.”

Larry is something of a firebrand as he makes the case for passive investing, but he’s also a proponent of what his firm calls “evidence-based investing.” What that means is that Larry won’t be taking any prisoners, but he’ll also gesture with reality-based openness toward active asset management.

In other words, Larry—like Dave Nadig—might tell you that active managers are “dead men walking” in the money management industry, but they''ll also make plain that active management can and sometimes does beat out passive. Also, they'd stresse that speculative investors are crucial to price discovery in financial markets, but also make clear that choosing an active manager does come at a price.

The takeaway is this: Folks like Larry, Dave and me consider it our jobs to make sure investors understand that price.

Follow Olly Ludwig on Twitter @OllyLudwig.