Active, passive, and smart beta: where investors may be missing the mark

March 1, 2018

When we take a closer look at where investors are putting their money, we find widespread evidence in our research of what we might call asset misallocation. Simultaneously over- and underexposed to both actively and passively managed investment strategies, many investors may be missing out on the strengths offered by both, as well as the unique hybrid features of smart beta.

Using the equity categories defined by Morningstar, we found that investors had a surprising preference for active strategies. Twelve of the 16 Morningstar style box categories—which include the 9-box U.S. equity grid and 7 non-U.S. categories—reflected active allocations above 50%, while 7 categories showed active allocations above 80%.

We discovered that investors are far more likely to allocate to passive funds in core categories such as large-, mid-, and small-cap blend, but are inclined to allocate predominantly to active strategies in non-U.S. and growth equity. While this industrywide snapshot doesn't illuminate the specific ways or reasons why investors and their advisors may seek a balanced or biased asset allocation—nor how this picture may be changing—it does reveal a broad emphasis on active versus passive strategies that’s worth exploring.    

Consider the propensity of active funds to outperform

We recently conducted a study in which we sought to determine how hard it can be to locate stock fund managers who can beat their benchmarks. This research revealed that the odds of finding an outperforming active manager are better in some equity categories than in others.

To help ensure our study’s results were robust, we looked at rolling 10-year fund performance data over a 20-year timeframe. That is, we averaged performance results for active funds in each equity category across a series of trailing 10-year periods that differed only in monthly increments. The results of this high sampling method of looking at returns led to our key insight: In some equity categories where investors favored passive strategies, it was apparent that they might have achieved better results if they opted instead for actively managed fund options.

Conversely, we also found that in other categories where investors favored actively managed funds, they appeared to be missing out on the relatively stronger results available through passive or smart beta strategies. Investors, it seemed, were focused on active when they could have been reaping the persistently more attractive results of passive funds, and they were focused on passive when they might usefully have considered active funds.    

Consider the example of small-cap blend. Here, industrywide allocations to actively managed funds stood at a tentative 43%, versus 57% for passive. But we found the likelihood or propensity of active approaches to outperform in this category to be 60%, which is relatively high. In other words, with 6 in 10 actively managed funds delivering long-term benchmark-beating returns in this category, it seems that the argument for small-cap blend assets to tilt in favor of active funds is strong.

Or consider the case of mid-cap value, where the opposite tended to be true. Roughly 30%, or 3 in 10, managers have outperformed their benchmarks over the long term in this category, and yet 77% of assets in this category are actively managed. This strikes us as a more obvious case where smart beta and passive strategies may deserve closer attention from investors and advisors.    

A word about smart beta

Smart or strategic beta is a hybrid type of strategy that combines elements of active management decision-making with the systematic, rules-based investing of passive management. These strategies are typically available at a lower cost than their active counterparts, but they generally have the potential to outperform their benchmarks—unlike purely passive, market-cap-weighted index funds and ETFs. Given this potential, these strategies may be worth closer attention when the prospect of finding an outperforming active manager appears low.   

Consider the magnitude of outperformance

In addition to looking at the likelihood of outperformance, it helps to understand where the biggest pots of potential alpha—or returns above a benchmark return—may be found among the available investment options. In other words, if you could pick top-performing active managers across any investment category, where could you arguably get the most bang for your buck? In our study, we called this magnitude. A useful analogy for this might be thought of in terms of fishing. When you go fishing, you generally want to catch bigger rather than smaller fish. Magnitude tells us whether the “pond” of a given equity category is likely to contain small fish (low magnitude results) or big fish (high magnitude results).

Again, using 10-year rolling periods to frame our conclusions, we looked across the equity style box to rank categories by their average excess returns versus their benchmarks. In the best of cases, we found the highest ranking (first percentile) foreign small/mid growth fund outperformed the benchmark by 655 basis points annually. Clearly, this is a category in which top managers may land some big fish. Contrast that with a first percentile mid blend equity fund, which on average outperformed the benchmark by 216 basis points annually.    

Magnitude of potential outperformance

Of course, given that choosing a top active manager in any category may feel impractical, our study also calculated magnitude results for funds in the top third of their respective categories over rolling 10-year periods. While results for funds in the top 33% are not an exact match with results for the top 1% of funds, they bear a strong family resemblance overall. In our view, this suggests there may be some continuity of magnitude results across different segments of the equity markets.   

Develop a framework for allocating to active, passive, and smart beta

To develop a framework for equity allocations, we think it helps to consider the big picture of propensity and magnitude. Where these factors are uniformly high—meaning there's a better than 50% chance of finding an outperforming manager and a general pattern of larger magnitude historical returns—it may be reasonable to tilt toward actively managed funds. Where these factors are uniformly medium—which we found to be the case, for example, in the Morningstar large-cap blend category—it may be worth considering all of the available options across active, passive, and smart beta strategies. And where signals are more mixed or uniformly low, passive and smart beta approaches may arguably warrant the lion’s share of your attention.    

FOR INVESTMENT PROFESSIONALS ONLY: Explore an in-depth discussion of how to develop a framework for equity allocations in our white paper, "Combining active, passive, and strategic beta investing."