Passive investments have come a long way over the last five years, and I, for one, am glad we seem to have collectively moved past the rather tired ‘active versus passive’ debate.
However, a by-product of this debate is the creation of a toolbox of different funds. We believe that by being agnostic when approaching this toolbox, a combination of both active and passive strategies can allow for a greater amount of flexibility in deploying an investment strategy.
Recent launches have prompted fresh debate, sometimes simply by virtue of their names. The term ‘smart beta’, for example, implies on a derogatory basis that any other strategies are not as intelligent.
However, when these funds are stripped back to their basic strategies, it becomes apparent that many are based on a type of factor investing: in very basic terms, the investment process where securities are chosen based on attributes associated with higher returns, and defined by distinct and identifiable characteristics.
Benjamin Graham was a very early pioneer in terms of establishing the concept of value investing in the 1930s, but since then a number of other factors have been developed. As well as value, the factors of size and momentum are now well established, along with the more recent quality factor which is arguably borrowed from the investment processes in the active fund management industry.
Used within an appropriate investment strategy, these factors can add value to a portfolio, be it through a ‘smart beta’ passive instrument or through an active manager with these factors embedded in their investment process. Therefore this strategy is not ‘smart’; rather it is a certain style and approach to investing, and one not necessarily any wiser than its contemporaries.
In particular, it should be recognised that many of the approaches in ‘smart beta’ are exploiting what appear to be pricing anomalies. It’s therefore essential that investors have reason to believe the anomaly will persist in future, and that they understand what is driving this anomaly – for example, behavioural factors or risk factors not captured by volatility measures.
Indeed, as with all style investing, the strategies will perform differently within different types of markets. What does well in rising markets has to then weather the storm in down markets. For the most part, value stocks can generate good returns in rising markets, but these can be wiped out in crashes. On the other hand, quality indices can outperform falling markets due to low leverage and steady earnings; however they can be expensive and lag behind rising markets.
‘Smart beta’ products are a welcome addition to the toolbox, allowing investors to express specific elements of investment strategy in a cost-effective way.
However, each comes with its own set of pros and cons, and market conditions that favour or disfavour them, just like everything else. There are no silver bullets here.
Ben Seager-Scott is Tilney Bestinvest’s director of investment strategy
