Could active funds benefit from ‘smart passive’ growth?

John Kenchington

The rise of ‘smart beta’ funds, as highlighted in a recent report by Nomura, has ramifications for the active fund management debate.

The funds allow ‘passive’ investors – ie, those who want to buy a market in a basic, low-fee way – to adopt style biases, for example focusing on ‘value’ companies.

They work by trading in new market indices that automatically adjust their weightings towards stocks based on their basic financial qualities.

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This differs from standard passive funds tracking standard market indices, which are mostly weighted based on the market size of their constituents.

Smart beta can be delivered at similar price levels to existing passive funds because it requires no human selection, as in active funds, or advanced computerised strategy, as in quant funds.

Here’s the interesting thing though, touched upon by Nomura.

As smart beta funds proliferate, this raises the question of whether we still need to be fixated on the idea that market size-weighted indices are the fundamental worldview against which everything else should be judged.

When we talk about whether we ‘beat the market’, we mean compared to the market’s capitalisation-weighted indices.

But we could just as easily live in a world in which the main ‘standard’ indices were actually equally weighted, where all shares represent an equal portion of the benchmark.

In that scenario, the decision to instead invest in a capitalisation-weighted benchmark would be viewed as an active ‘smart beta’ decision that would ‘win’ or ‘lose’ you money relative to the equally weighted worldview.

If we lose our obsession with the standard capitalisation-weighted worldview, then we’re faced with a disturbing prospect.

In fact, whenever an investor buys any passive fund – be it capitalisation-weighted or otherwise – he or she is making a style decision about the market they are investing in.

To me, the implications of this are significant.

In the past, before buying an actively managed fund we needed to ask ourselves whether it was worth spending more on because we thought the fund would outperform a capitalisation-weighted passive fund.

But now the question we need to ask is whether we think we can pick a market style that will work for us, be it to equally weight, capitalisation-weight or weight based on valuation metrics, etc. Or, in the face of all of that choice, might we be better off just paying the extra basis points to let an active manager do it for us?

In the long run, perversely, this removal of the safety net that capitalisation-weighted indices ‘are the market’ could lead to a resurgence of active management.

I know I’d rather pay the extra basis points to a top-notch, benchmark-oblivious active manager than trying to build my own strategy from scratch.