Few issues in the investment industry have generated as much interest, noise and derision as the emergence and promotion of “smart beta” products. In response to the fabulous success of Exchange Traded Funds (ETFs) which initially were organized around the beta of traditional, cap-weighted indexes, smart beta aims to tweak index construction away from capitalization weighting and towards any number of other factors: value, yield, growth, momentum, equal weighting and a few others.

There is a sound rationale for considering and exploring passive constructs based on factors other than capitalization weighting. It is entirely likely that some of these strategies will deliver a better risk and return profile than cap-weighted strategies, and evidence from market returns is beginning to bear this out.

As an active large cap stock picker and portfolio manager in a previous position, buying more of a name simply because other investors had pushed it higher was exactly the wrong reason. And since I did not want to re-invent my workflows every day, I tended strongly to organize my stock picking preferences around a small subset of factors I believed delivered excess returns and alpha. Truth is most stock pickers must organize their process around some combination of market factors they optimize for. And every active management shop proudly displays their process in their marketing material.

As the active management complex has seen their asset inflows stall and reverse in recent years and concurrently witnessed the huge asset inflows ETFs have captured, it stands to reason that entrepreneurial capitalists would enter the fray. And as they see fees across the ETF complex that are a small fraction of their active management fees, it is only natural for them to contemplate manufacturing strategies with higher fees, even active management fees. Enter Smart Beta.

Balancing Fees and Net Returns to Investors

The timeless dilemma of active management is that if a manager is able to deliver excess return, much or all of it is retained by the manager in the form of active management fees, leaving the investor with net returns that are little different from passive returns. If the active manager is not able to deliver excess returns, the investor has paid excess fees to underperform a passive benchmark…an untenable proposition. This is the proposition that led the venerable John Bogle to posit: “in investing, you get what you don’t pay for” and to found the passive management fund titan Vanguard.

This tension between net returns to investors and the economics of investment managers is a delicate one. Better economics and margins for the manager always come at the expense of the investor. The rapid adoption and growth of ETFs is a strong endorsement by investors and advisors that low-cost pure market exposures are ideal. Having said that, we believe that market capitalization is not the only factor worthy of consideration in the construct of a passive strategy.

Value, yield, growth, momentum…if a strategy organized around some combination of these and other factors can enhance returns, limit risk or both, why not manufacture strategies around them? Investors don’t want drill bits, they want holes. However, there is no reason why a passive rules-based portfolio construct organized around factors other than market cap should be priced any differently than a cap-weighted passive product. As Ben Johnson from Morningstar said at this year’s Inside ETF’s Conference: “don’t pay active management fees for passive strategies.” Amen.