What is smart beta, and is it a better passive investment strategy? [video]

Is the line between active and passive investing getting blurred?

    When does a passive investment strategy become active?

    Factor investing, or so-called smart beta, is a more active form of passive investing. Here's an explanation of how it works, how it could result in higher returns, but will require patience and a greater risk tolerance.

    Discussing the active decisions even passive investors have to make:

    Robin Powell: Hello there. People often talk about active and passive investing as if they’re two completely different things. The reality is more subtle than that, and in fact, one of the biggest developments in recent years has been the emergence of a third type of investing, which is neither passive nor in the conventional sense active. Michael Batnick blogs as “The Irrelevant Investor”:

    Michael Batnick: Unless you are weighted to the global market cap opportunity style, which nobody is, you’re going to be active to a certain degree. In other words, just because you’re not actively trading you have to make some decisions. Does that make you an active investor? I don’t think so. If you go outside and you don’t bring an umbrella, are you actively saying that it’s not going to rain? No, there are just some decisions that you have to make.

    So let's start with the fact that indexes are traditionally cap-weighted. In other words, Apple is with a lot more in the S&P 500 than fossil, for instance. Now there has been a big revolution about smart beta and breaking away from the traditional cap-weighted indexes. So you can wait by the dividend stream, you can wait by other fundamentals such as price to earnings or what have you.

    So, there is a big surge of these sort of funds coming to the market and the truth of the matter is that these Smart Beta, ETFs or factor investing or whatever you want to call it, that break from the traditional cap-weighted model, have a big tilt to value, stocks and to small stocks. So if you want a regression, you are going to see that much of that return is derived from those two factors that have been around for decades and decades and decades.

    RP: So, are these middle-way strategies — whatever you choose to call them — a good idea? Well, you have to remember that although they are expected to deliver higher returns, there is a price to pay in the form of greater risk. Many investors are too impatient. They expect outperformance far more quickly than is reasonable.

    MB: Any of the Smart Beta strategies work on their own over a reasonable period of time. But to think that you are going to beat the market over one, two, three year period is really misunderstanding what the products do.

    So, if you can build a portfolio that you can stick to, that’s probably more important than the strategy itself. Whether you want to equal weight them, tilt to value or whatever you are comfortable with. But I think one of the issues is that people that had been chasing the mutual fund managers might experience similar behaviour with these Smart Beta products. I think they are the most in danger.

    RP: So, be realistic. Yes, you should, over time, be able to produce a higher return than a cap-weighted index. But you’re going to need to be very patient.

    Goodbye.

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