Passive vs. Active: Smart Beta Blend Intensifies Investing Debate

The explosion of exchange-traded funds (ETFs) and automated, or “robo,” strategies using ETFs has cranked up the volume in the debate that pits passive investing against active investing.

But this dispute is already more than 30 years old, originally pushed into the investing vernacular with Burton Malkiel’s seminal book A Random Walk Down Wall Street. And now? The coming of age of the “smart beta” blend of passive investing and active investing brings this three-decade discussion to a new generation of investors.

Question for the Ages

Proponents extoll the virtues of passive investing versus higher-cost approaches, including actively managed mutual funds and individual stocks and bonds. In Random Walk, Malkiel postulates that if you don’t have time to micromanage your investments, you should simply invest in an index fund. The author also argues that outperformance of an index by actively managed funds is not possible over the long term once you factor in fees and trading costs.

Malkiel’s debate has new life thanks to the rising popularity of automated investing strategies using ETFs by so-called “robo-advisors.” They generally use an asset allocation strategy based on relatively low-cost, index-based ETFs—a passive approach.

White-Glove Service?

The hands-on investing contingency routinely has to field the big question: is it worthwhile to pay for active management?

In general, one can measure large-cap, growth-focused mutual funds versus the broad-based S&P 500 (SPX) and discover that most funds using the SPX as their proxy have not beaten the index. As an example, Bill Miller, the closely followed portfolio manager of the Legg Mason Value Trust, outperformed the SPX for 15 straight years from 1991 to 2005. Although this was an impressive streak, Miller recognized in a 2005 Wall Street Journal article that some of his outperformance was due to luck and timing. The fund went on to underperform in five of the next six years before its skipper’s 2011 retirement. Mathematics ultimately leveled the playing field, although Bill had a great run for more than a dozen years.

Now, does the equation change outside of large-caps and other seemingly straightforward stock strategies? Yes. For instance, some investment professionals argue that active strategies in markets where transparency and liquidity is lower—such as emerging markets—can outperform their benchmarks.

And that begs another question: is there a distinction between skill and luck when it comes to these returns? Eugene Fama and Kenneth French had a little something to say about that in their paper “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” They found that most funds underperformed their respective U.S. stock benchmark by about the same amount as their management fees and other costs. Further, they said, it’s difficult to identify funds that exhibit the skills to consistently outperform the broader market. The original analysis focused on mutual funds versus index funds, but has expanded to asset allocation methods, including whether a strategic or tactical method is better than another.

Enter: Smart Beta

More recently an approach called smart beta has made some headlines, touted as the best of both worlds. With it, strategic versus tactical asset allocation follows the similar theme of active versus passive investing, but has more to do with asset allocation rather than the selection of a mutual fund versus an index fund. The argument is complicated by the fact that both strategies at various times exhibit outperformance versus the other.

Smart beta proponents recognize and challenge existing benchmark construction, arguing it has inherent flaws because it’s based on price or capitalization. In other words, the non-smart-beta approach overweights larger components in an index, which then has a disproportionate effect on index returns. Smart beta proponents say their approach—by equally weighting securities, selecting the most undervalued component as measured by price/earnings, or by some other empirical method—arguably can provide better returns or lower risk and therefore has a value beyond traditional indexing.

Smart beta strategies are in their infancy and do have detractors, including John Bogle, the legendary index investment proponent. But they may be worthy of investigation, and certainly some observers see smart beta earning a permanent role in the construction of passive strategies mixed with elements of active management.

Your Own Mix?

So, where does that leave us halfway through 2015? All camps are passionate about their respective investment strategies, and it will likely always be that way.

Rather than argue about which strategy is best, the engaged investor might be best served to review his or her goals and personality. If you’re lacking time or desire to do your own homework, maybe a passive approach is best. Meanwhile, those who love to feel the controls in their own grip are likely to go for an active strategy. Or maybe the best option is combining attributes of each: the smart beta approach.

Wherever you land, having a strategy—period—is the first step toward financial freedom.