Getting Active with Passive
Passive investing has revolutionised the investment management industry, which has up until recently been dominated by unlisted active managed funds.
Due to their simple, low-cost fee structures – many investors from retail households to the most sophisticated institutions are increasingly adopting passive ETFs (exchange traded funds) as a tool within their portfolios to gain market beta exposure, or even tactically as a return enhancer or risk mitigator.
Whilst active managers would argue that their value-add comes from their security selection and market timing abilities to generate alpha, data from S&P’s SPIVA scorecard shows that most active funds actually underperform their benchmarks over different time periods. For example, 68.10% of Australian equity funds underperformed the S&P/ASX 200 benchmark over the last five year period to 30 June 2024. This increases to 82.16% going out to 10 years.
In addition to persistent underperformance, we also see that active funds generally:
- carry higher fee structures in terms of both management and performance fees,
- produce most of their alpha from upweighting a factor exposure (such as growth, quality or value), rather than security selection
For these reasons, we can see why the trend in flows has moved towards passive investing through an ETF wrapper.
As the industry continues to evolve, ‘smart beta’ strategies have also become increasingly popular due to their unique ability to provide the best of both passive and active worlds. Smart beta is simply any passive investment strategy that uses some measure other than market capitalisation to determine weightings in a portfolio. For example, a quality ETF may target metrics such as low debt to equity, high return on equity, and high profitability characteristics to provide a consistent exposure to the quality factor. This is not dissimilar to what an active manager will do when filtering down the investible universe into securities which exhibit these characteristics. However, because smart beta strategies follow a rules-based approach, investors are able to harness the return premia that comes from upweighting a factor like quality, value or growth at a fraction of the cost to what an active manager will charge.
By design, smart beta strategies aim to provide investors with excess returns with minimal tracking error or volatility and have become increasingly adopted as a core ‘building block’ within portfolios as investor sophistication evolves.
Author: Hugh Lam, CFA, Investment Strategist at BetaShares
