The Evolution of Passive Strategies
We recently wrote a two-part article (Part One and Part Two) discussing some of the merits and characteristics of both active and passive investment strategies and our thoughts on how and when we look to use each. The debate on the advantages and disadvantages of each will undoubtedly persist and much like the passively-oriented strategies at the center of the debate, it will also continue to evolve.
In our earlier article, we purposefully provided a simple explanation of what constitutes a passive strategy. In this discussion, we will expand on that narrow description and touch upon the rapidly expanding universe of what falls under the “passive” umbrella.
The first passive index fund was launched in 1976 by Vanguard with a mere $11 million in assets. It was a full 10 years before Vanguard launched its second index fund, a bond index fund, and an additional seven years before the first Exchange Traded Index Fund (ETF) began trading on the American Stock Exchange. Initially, these passive index funds and ETFs focused on providing very broad, cheap market exposure to investors. The growth of such strategies was not embraced by the asset management and brokerage industry, as it threatened the high fees and commissions that were commonplace. While broker and advisor adoption was slow, passive strategies did eventually gain traction and by the end of 2015 there were an astounding 1,800+ ETFs available in the United States.
Passive Strategies Today
Passive strategies now exist not only for broad segments of most asset classes but for increasingly narrow subsets of investments and markets (specific countries, styles, industries, themes, etc.). The rapid and continuing growth in the passive opportunity set available to investors has also necessitated a need for creative thinking around the construction of these strategies. The industry has conveniently and presumptuously coined this evolution around passive portfolio construction “smart beta”. To be fair, the industry is still wrestling with the right nomenclature and also refers to them as fundamental indexing, alternative beta, enhanced indexing, or even hybrid strategies. Even the industry cringes at the “smart” tagline as it implies that the traditional or early passive strategies were dumb, which they certainly are not.
The early and still most popular passive strategies were constructed based on the market capitalization of the stocks of the companies making up the index or fund. So the determining “factor”, simply put, is size. For example, Apple Inc. has the largest market capitalization of any company in the S&P 500 index and accounts for roughly 3.1% of funds focused on that index, whereas Coca-Cola Company accounts for just 0.9%. There are, of course, any number of other factors or security attributes (dividend yields, valuation metrics, number of employees, etc.) that could also be used to not only define security weights but to define which securities are included or excluded. That is the basis for what we’ve referred at this point to as “smart beta” strategies. Instead of simply using one size-based factor, providers are selecting other or additional factors as part of their portfolio construction. The reason and rationale for other factors is a topic for another day, but typically driven by a drive to target a specific part of the market (high dividend yielding stocks), reduce volatility, or even outperform a benchmark (yes, they just can’t help but try!). How meaningful is the construction methodology? Consider that over the last 10 calendar years the performance of the S&P 500 Index (market cap weighted) and the S&P 500 Equal Weighted Index (each security gets the same weighting) has differed on average by over 2.1% per year and in one year differed by nearly 20%! It’s safe to say, portfolio construction matters.
Wall Street Cashing In: Good or Bad?
It should come as no surprise that this derivation of the passively-oriented strategies has garnered both investor and Wall Street interest. Wall Street rarely misses an opportunity to capitalize on a product trend and it reminds me of one of my favorite quotes from the venerable Warren Buffett.
“A pack of lemmings looks like a group of rugged individualists compared with Wall Street when it gets a concept in its teeth.”
There is no question that Wall Street is off and running already with this concept, but that doesn’t necessarily mean that the development of new approaches is inherently a bad thing. It does, however, mean that advisors and investors must be thoughtful in selecting and monitoring strategies and securities. The complexity and nuances continue to grow and the selection of a passive strategy still requires significant and ongoing research and due diligence.
Perhaps the best analogy would be the rapid growth and eventual issues that arose from the development of the CMO (collateralized mortgage obligations) market. The basic CMO structure and concept was sound and initially a positive for investors and borrowers, as well as of course the banks. Without diving too far into the details, what was initially a positive development over time morphed into something completely unexpected (I was going to say unintended, but I think some may argue that point!).
By the time the financial crisis rolled around CMOs were really only truly understood by those constructing them and investors (retail and professional alike) had become complacent and were readily bypassing one of Peter Lynch’s (of Fidelity fame) investment tenets “know what you own, and know why you own it”. While we’re certainly not making the argument that these “smart beta” type strategies are going to cause the next financial crisis or anything of the sort, we do want to emphasize that regardless of whether or not a strategy is active, passive, or some hybrid of the two it is still very much caveat emptor.
As we stressed in our introductory article about active and passive strategies a few weeks ago, our preference is to utilize passive strategies, but as you can tell, the work and decisions do not end there. While much of what Wall Street has and will develop and market as “smart beta” will be nothing more than an asset grab, the idea of utilizing new, additional factors in the construction of these strategies makes intuitive sense.
We fully expect further evolution in this space as it matures and believe many of the developments to be true improvements and as such we at Smith & Howard will continue to explore ways to capture the benefits for our clients. To paraphrase a former colleague, “it’s ok to be a skeptic, just never a cynic”.
I would be happy to discuss our philosophy in more detail with you or to explore with you how SHWM can work with you to achieve your financial goals. Please call me at 404-874-6244 or email me here.