Passive investment products − a rose by any other nameMay 26, 2015
Passive products continue to thrive in the market. By some estimates, these products are now the primary investment choice for the majority of Americans, as suggested by Morningstar’s finding that nearly two-thirds of investor inflows last year went to passive investment products. Perhaps the more interesting tidbit to come out of the ETF trends last year is data that, according to a report by Invesco PowerShares, Smart Beta ETFs accounted for over 17% of U.S. ETF net inflows in 2014, despite representing only 11% of total ETF assets. In light of the insistence of many in the industry that active investing is futile, and particularly given the dismal relative performance of active management in 2014, this trend may seem intuitive on the surface, but should actually be somewhat surprising. After all, Smart Beta is active management, no matter how product providers spin it.
It can be argued that the ultimate truly passive portfolio is the market portfolio − a portfolio consisting of every asset in the world weighted in proportion to each asset’s market value. Of course, this portfolio only exists in theory, and its use in financial models is based on some pretty hefty assumptions, so market cap-weighted indices segregated by asset class have become the norm to represent passive exposure to a given asset class. If we assume that market participants in aggregate and over time are efficient allocators of capital and therefore of valuing assets, a broad array of market cap-weighted indices taken together should at least approximate that theoretical market portfolio. Thus, an investor who truly wants to be passive should invest in only those market cap-weighted benchmarks. As with any asset pricing model, the point that market cap-weighting is truly the definition of passive investing depends on the theory of efficient markets, and as with any theory, it has its faults. If you are of a mind that market participants are not efficient allocators of capital, and I would not disagree in the short term, then of course even market cap-weighting may seem like an active choice, another form of Smart Beta. In that scenario though, how would we define passive investing? A topic for another blog post, and another theory, I think.
Smart Beta products, which generally refer to products tied to indices based on alternative weighting methodologies (i.e., anything other than market cap-weighting), are by definition then not passive, despite them being labeled or sold as such. Any deviation from a market cap-weighted benchmark is an active investment decision, even if it is a move as simple as equal weighting. All styles of active management, Smart Beta included, will experience performance cycles. So while an investor might believe they are getting passive exposure to an asset class with Smart Beta, and perhaps the fund flow data suggests many may very well believe just that, they are in fact investing in a strategy with many similarities to traditional actively managed funds. Smart Beta investors should recognize that although Smart Beta can offer performance improvements over traditional benchmarking, it is not without added risk.
Many Smart Beta products offer intriguing ways to gain exposure to different asset classes and themes. And it is true that some of these products can be seen as falling somewhere on the spectrum between passive and active investing, so perhaps the trend noted above is due to informed, but perhaps disillusioned, investors slowly weaning themselves off active management – a step down program, if you will. However, giving these products a buzzword label like “Smart Beta” should not overshadow the fact that they are in actuality active vehicles, and expose investors to other-than-passive risks.