A senior manager at a passive fund management firm once noticed a younger colleague doing something he shouldn't have.
The senior manager yelled at the junior colleague: "Don't just do something – sit there!"
This is a joke active fund managers tell about passive fund managers.
It isn’t all that funny, but it betrays a common misconception about passive management.
Rather than sitting around idly, passive managers are responsible for much of the innovation within the financial services industry.
This innovation provides investors with new choices and opportunities.
Investors now have cost effective access to “passive” tools that can outperform the markets, which is something investors have traditionally paid more expensive active managers to do.
The world of passive investing comprises far more than just sitting there.
As you know, an active manager’s job is to beat a fund’s benchmark index.
If the index returns 10 per cent, active managers aim to return more than 10 per cent.
If the index falls 10 per cent, active managers aim not to fall as low as 10 per cent.
Most active managers use a market capitalisation index as the benchmark they attempt to beat.
Active managers call their outperformance 'alpha'. They refer to the performance of the index or the market as 'beta'.
Beta is also used as a term to measure correlation (ie. correlation to the market benchmark).
The benchmark of international equities, for example, is the MSCI World ex Australia Index and the index has a beta of one.
A fund manager with a beta less than one would experience smaller price movements than the MSCI World ex Australia Index.
Conversely, a beta higher than one would entail bigger price movements than the MSCI World ex Australia Index.
The very first exchange traded funds (ETFs) tracked traditional market capitalisation benchmark indices and were seen as tools for beta exposure.
Their portfolios had betas of one. Investors soon started to question whether these benchmarks made for good investment portfolios.
One of the early challenges was related to the use of market capitalisation weights.
An ETF that tracks a market capitalisation index allocates more to bigger companies than to smaller companies.
When the market overvalues a stock, a fund tracking a market capitalisation index buys too much of the overpriced stock.
Conversely, when the market undervalues a stock, the fund sells too much of the underpriced stock.
For investors seeking maximum returns, this is not ideal.
Index providers reacted by creating indices that targeted better returns than the traditional benchmark, for example, by capping the weighting for larger companies or even equal weighting the portfolio.
These innovative index construction techniques became known as "smart beta." As with most jargon, the definition of smart beta has been hijacked.
There is no industry consensus on what smart beta actually means. Some define smart beta as any type of index that is not market capitalisation-weighted.
Others define it as investments that apply screening techniques or use company data to narrow the portfolio or adjust weightings in existing indices.
Either way "smart beta" can be thought of as the intersection of active management and passive investing.
It has the intention to outperform the market using data techniques in place of active managers’ judgement to select and weigh stocks.
Australian institutional investors have been employing smart beta strategies to achieve outperformance, or alpha, relative to market capitalisation benchmark indices for some time.
Smart beta strategies have taken off globally with over $US 65 billion of inflows during 2013 allocated to smart beta ETFs, according to BlackRock.
Russel Chesler is the director for investments and portfolio strategy at Market Vectors Australia.
