Smart Beta Series: Episode 1 - Passive Management
The rise of “Smart Beta” has been something to admire over the course of the past 13 years. From humble beginnings to a term that encompasses a wide range of offerings across the globe that is starting to eat the lunch of many an active manager.
So, the question is “what is smart beta” and no, the opposite being “dumb beta” is not the answer.
The active versus passive investment management debate is one that has been waged since the beginning of time (not literally but it certainly feels that way). So perhaps let us start by defining what the difference is between active and passive management. Today we will talk about passive investing and what this means for investors. This will be followed by a few other episodes in the coming months that will explain Smart Beta and its importance in investment management in the modern day and age for the modern advisor and investor.
Passive investing is something that rose to prominence in the 1970’s and was originally solely focused on the performance replication of a market index. For example, getting exposure to the S&P 500 or the JSE All Share Index. This form of investing has increased in popularity as investors have chosen to try and harvest beta instead of alpha when investing. The market for passive investing of all kinds is currently $16 trillion as of 2016 and makes up around 17% of the worlds global assets under management (see PWC report).
In a nutshell, and in a very uncomplicated fashion, if you are trying to get beta you are effectively trying to get the risk and return of the overall market. In other words, if you hold and index that represents the market both from an investment universe and weighting perspective you have achieved the same risk and return as the market and have earned beta.
Alpha, which is the opposite of beta, is the positive/negative return earned by investors relative to the market index or (beta) which is achieved by investing in a different fashion to that of the market index or (beta.) For example, if the index has a weight of 15% to Naspers as a result of the size of Naspers in relation to the rest of the market and an active manager chooses to hold 25% in Naspers instead of 15%, he will have an active weight in Naspers which will either lead to positive or negative alpha relative to the market.
Passive management has evolved into a wide array of offerings, but a purist will state that passive management only really caters for the investment in market indexes that are weighted according to their market capitalization weights. In the equity space that means the market value of a company’s outstanding equity. If you have 2 stocks in a universe and they both have 100 shares outstanding. Stock A has a price of R80 and stock B has a price of R20. Then the market cap of Stock A is R8,000.00 and market cap of Stock B is R2,000.00. Therefore, the total universe has a market cap of R10,000.00 (R8,000.00 + R2,000.00). Stock A will have a weight of 80% (R8,000.00 / R10,000.00=80%) and Stock B will have a weight of 20% (R2,000.00 / R10,000.00=20%) This is often re-weighted on a quarterly basis but will depend on the index provider and their re-balancing methodology.
Now that we understand some of the basics of passive management let’s look to some of the benefits.
Diversification: Passive investing tends to give investors exposure to a wide index of assets as opposed to having concentration investment positions of a few securities only. This tends to be the approach of active managers. In a traditional sense, you hold the risk and return characteristics of the whole market and should perform in line with the market. In the case of the S&P 500 for example, you will have exposure to 500 stocks in the same weights as those of the market. Your return should replicate as closely as possible the return of the market index. This spread of investment allocations means that you are eliminating company specific risk, leaving only market risk, which cannot be further diversified away.
Low Cost: Passive investing in its most basic form is simply the replication of a market index which is rebalanced and reconstituted from time to time. The benefits of simply replicating an existing index is that there are not large resources deployed to research, operations and for the most part the amount of trading, turnover and taxation. This tends to be a magnitude smaller than in comparison to active counterparts. This makes this form of investing very attractive as over the course of time costs tend to have a significant impact on investor outcomes.
Simplicity: Not only is the investment easy to implement but it is simple to understand, access and incorporate into portfolios. The need for complex due diligence and on-going assessment of management teams and holdings is not required. The understanding of strategies is also not needed. Simply put it is the simplest way to get access to investment markets in a low cost and diversified fashion without any complexity.
In summary, we are not concluding that passive investing is the only way investors can or should invest, but passive investing is an important aspect of the investing universe. This is a tool that all investors and portfolio managers have at their disposal and is certainly a popular one for many investors in the modern day and age.
We will spend more time on other elements including active management and smart beta strategies in the remainder of the series and conclude how 1st Fusion incorporates these elements into client portfolios on an on-going basis.