It might be said that for many years the pre-eminent way of looking at investing was through security selection and market timing. These are the primary tenets of active management as practiced currently.
Many of these ideas were first spelled out by the great Benjamin Graham in his books Security Analysis and The Intelligent Investor, both written before 1950. More than half a century ago, a man from Princeton named John Bogle created what many now view as the world’s first index fund. Instead of doing things the way that Mr. Graham advocated, Mr. Bogle put forward the idea that cost was a major drag on investment performance. Some years (and more than a few slammed doors) later, Bogle founded a mutual fund company called Vanguard. You may have heard of it.
Despite considerable backlash—including allegations that Bogle was “un-American”—Vanguard is now one of the largest money managers on the planet and is taking in net new assets to the tune of about a billion dollars a day. Mr. Bogle likes to quip that he is less concerned with the efficient market hypothesis than he is with the “cost-matters hypothesis.” In essence, he doesn’t care about how efficient or inefficient markets are. Rather, his concern is one of simple cost minimization.
Many people, me included, are primarily opposed to most active management because of the associated costs. If someone could come up with a competitively priced active product, most—perhaps even all—objections would disappear.
By way of example, many people are surprised to learn that about a third of Vanguard’s total assets under management are managed actively. Rather than picking stocks directly or using mutual funds where a manager is trading stocks on behalf of similarly minded investors, traditional index funds aim to replicate the returns of any given benchmark while aiming to minimize both costs and something called tracking error. In essence, many index funds pride themselves on just how accurately they can track their respective benchmarks. Less tracking error means you have a better, more reliable product.
Similarly, a little over a quarter century ago, the world’s first exchange-traded fund (ETF) started trading right here in Canada. In a nutshell, ETFs are a lot like index funds because they aim to track a given benchmark. The difference is mostly one of structure. In contrast to mutual funds, which trade once a day based on the market’s closing price, ETFs, as the name implies, trade on stock exchanges throughout the day like a traditional stock.
In the time between the creation of the index fund and the creation of the exchange-traded fund, a third kind of company was founded. In 1981, David G. Booth and Rex Sinquefield, both graduates of the University of Chicago’s School of Business (now known as the Booth School of Business) founded Dimensional Fund Advisors (DFA). Dimensional has grown to manage $663 billion in assets under management as of late May 2017.
Booth and Sinquefield had studied under Eugene Fama and were eager to build retail products that would apply his findings. Occupying the middle ground somewhere between traditional active stock pickers and indexers, the DFA funds added a twist. Some people call this factor-based investing or smart beta. Let’s use terminology that is a little less contentious and call it strategic beta. In essence, strategic beta follows certain principles (often referred to as rules) that cause investors to tilt their portfolios in favour of attributes they feel are likely to yield better outcomes.
The folks at DFA effectively straddle a line by aiming for the best of both worlds, using “tilts” toward known attributes that offered historically favourable risk/return trade-offs without incurring the high costs and taxes associated with traditional active strategies. In essence, Eugene Fama and his long-term research collaborator at Dartmouth College, Kenneth French, had shown that risk and reward were related and that it was reasonable to expect above average returns provided that one was willing to take on a reasonable and calculated amount of additional risk to get them.
Combining active and passive strategies
Strategic beta options offer a middle ground trade-off between traditional active (alpha seeking) products and strategies and traditional passive (beta replicating) products and strategies. This is a relatively contemporary third way of managing money. Given the animosity between the older and more prevailing views, you’d hope the debate and discussion about the relative merits of competing perspectives would be thoughtful and respectful. In fact, the spectrum between paradigms has blurred, but there are still some extremely distinct camps regarding preferences.
While DFA’s products are primarily structured as mutual funds (although DFA recently partnered with Manulife to offers a few new ETFs in Canada), it might be helpful to point out that most traditional passive products and a large percentage of strategic beta products are available using an ETF structure. As of the middle of 2016, there are about 2,300 different ETFs available worldwide.
In Canada alone, there are over 470 different ETFs, representing over $100 billion in assets from seventeen different product providers. In fact, the compounded annual growth rate in Canada over three-, five-, and ten-year periods has consistently been over 20%. Most of the rapid adoption of the ETF structure has been in the IIROC (securities) advisory platform.
Some people have quipped that the word smart in smart beta is really just an acronym for “Silly Moniker About Rules-Based Trading.” Others have noted with a bit of a chuckle that smart beta implies that it is the opposite of “dumb alpha,” which, I suppose, might be another way to describe traditional stock picking. While the terminology has its detractors, the important thing is that people understand what it means when people use it.
An excerpt from The Professional Financial Advisor IV (Insomniac Press), a guide that explores the complex relationship between investors and their advisors
John J. De Goey CFP, CIM, FELLOW OF FPSC is a Portfolio Manager with Industrial Alliance Securities (iAS) and the author of The Professional Financial Advisor IV. The views expressed are not necessarily shared by iAS.
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