Smart beta and market cap indexing: Better together

As Americans, we like to debate. Republican vs. Democrat, Yankees vs. Red Sox, Coke vs. Pepsi. In investing, we have debated the merits of active vs. passive for many years and, more recently, strategic beta (or so-called “smart beta”) vs. market cap indexing. The debate assumes that there is a right and wrong answer, but it’s not an either/or proposition; rather, when done thoughtfully, these strategies are better together.
Unlike the Yankees-Red Sox rivalry, in which loyalties seldom change, we don’t believe investors should choose sides when it comes to incorporating active, market cap and strategic beta strategies into their portfolios. The problem with those who perpetuate the various debates is they assume that the only outcome that matters is performance.
(More: Smart-beta upstart goes after the big boys wielding lower fees as a weapon)
But certain strategic beta approaches — specifically fundamental indexing strategies — serve as a nice complement to both market cap and active management options. Four key levers can help determine an appropriate weighting among these types of strategies: tracking error, loss aversion, alpha and cost.
MARKET CAP STRATEGIES
Market cap provides little or no tracking error (fees could provide a small drag), no downside protection (loss aversion) and no alpha, and has the lowest cost.
Strategic beta strategies have a relatively high tracking error compared to market cap, no downside protection, have historically delivered alpha and have low cost.
Active strategies have varying degrees of tracking error depending on the manager. Managers may provide some downside protection and seek to deliver alpha. They have greater flexibility and can adapt to changing market dynamics. And costs vary by manager and vehicle.
In considering if and how to use these strategies, we would suggest that advisers consider the following factors:
• What is the weighting methodology?
• What is the underlying index?
• What are the sector allocations?
• What is the breakdown of market capitalization?
• What is the value/growth tilt?
If advisers peel back the onion, they will see that these strategies are quite different. Certain strategies may exhibit large sector concentrations while others have pronounced small-cap exposure. Many will have value tilts but the degree of value/growth will vary over time and by strategy. If advisers spend time analyzing the portfolios in advance, they will have a better sense of how they may perform in a given market environment.
Much of our research has been focused on fundamental indexing, which is our preferred flavor of strategic beta because of the academic rigor and long track record. Fundamental indexing was introduced by Research Affiliates Inc. 10 years ago, and has been battle-tested in good times and bad. Regarding some of the “me too” strategies that have come to market recently, advisers shouldn’t assume that good back-testing equals a robust and meaningful test.
BETTER PORTFOLIOS
We recommend combining active, market cap and fundamental index strategies because this combo historically provides better risk-adjusted results.
There will continue to be innovation in indexing that falls under the strategic-beta umbrella. Most of the product proliferation to date has been across equity markets, so there is still room for innovation in fixed-income and alternative investments. Strategic-beta strategies will likely continue to blur the lines between active and passive investments. Many large asset managers have expressed interest in, and have announced plans for, strategic beta strategies.
Ultimately, advisers don’t need to take sides in the active vs. passive or strategic beta vs. market cap debates. Advisers need to understand the role that each of these strategies play, and consider combining them in a thoughtful fashion to achieve broad diversification over market cycles. Quite simply, we believe they are better together.
Anthony B. Davidow is a vice president, and alternative beta and asset allocation strategist at the Schwab Center for Financial Research.