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Is smart beta replacing active management?

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NEW ORLEANS - As active management declines and smart beta, or factor investing, becomes an increasingly attractive passive investment option for investors, it's more important than ever for financial advisors to carefully weigh the strategy's pros and cons.

Passive investing has reached "critical mass," with $6.7 trillion in assets at the end of 2017, or 37% of total assets under management in the U.S., says Michael Pajak, investment analyst at Envestnet.

Speaking at a session on active versus passive investing at the company's annual conference, Pajak noted that passive investment's share of the market is expected to reach 50% by 2023 and will grow to 68% by 2030, according to Moody's Investor Service.

"I don't see a trend back into active management," says Michael Hunstad, director of quantitative strategies for Northern Trust Asset Management, speaking at the conference. "A lot of active managers will say goodbye in the next 10 years."

A Moody's Investors Service report on the rise of the passive market predicted that the "next battleground for investor dollars [will] be in smart beta and multifactor funds, which will undercut traditional active products and offer similar potential expected return profiles."
A strong proponent of factor investing, Hunstad argues that "a lot of excess return [generated by active management] has been the result of factor exposure. It's hard to prove that active performance has not been the result of factors."

Those factors include size, value, momentum, low volatility, quality and dividend yield. "The great thing about factor investing is that you split the equity risk into pieces," he says.

Factor investing should be considered the "third leg" of an investment strategy, Hunstad argues, straddling active stock selection and index-based passive investments.

The biggest advantage of using factors, he maintained, is generating "excess returns without the high cost of traditional active management."

In an interview, Daniel Kern, chief investment officer for TFC Financial Management, agreed.

"A well-managed factor strategy can enhance portfolio returns, while keeping portfolio costs relatively low," Kern says. "In a low return world, costs can really make a difference."

"It's hard to prove that active performance has not been the result of factors," says Northern Trust's Michael Hunstad.

For Kendrick Wakemen, CEO of investment analytics platform FinMason, "the biggest advantage of smart beta is the ability to provide investors with greater control of the portfolio construction process. Specifically, the ability to better control diversification and align the portfolio more closely with an investor’s goals and outlook."

But investment professionals are quick to caution that advisors and investors also need to approach factor investing with caution.

"There are a lot of bad products out there," says Hunstad. "That means you can get a lot of unintended risk."

In addition, some factors are highly cyclical, and can be out of favor for extended periods of time, says Kern.

For example, value stocks were out of favor for much of the 1990s and relying on a single factor can create unintended risks, he notes.

"There is research that indicates that the size factor of investing in small company stocks is more effective when combined with the quality or profitability factor," Kern says. " The intuitive explanation is that having small company stocks without a quality or profitability screen can lead to a portfolio with 'bad' factors such as excessive leverage and low quality. It’s somewhat akin to having a diet with too much cholesterol."

A factor such as momentum can be expensive and tax inefficient, Kern adds. Nor should portfolio construction be overlooked, he says.

"I’m inherently skeptical of factor strategies that allow for too much concentration in a sector or industry," Kern points out. "Some low volatility and high dividend strategies end up overly concentrated in a limited number of sectors, creating unnecessary risk."

Another drawback of smart beta, says Wakeman, "is that some investors might think that the strategies are actually smart. The funds are not smart from the standpoint that they will always do well, or even well at all. It is just a different way of building a fund that gives investors more flexibility. It’s still up to the investor to make the right bets, which may or may not payoff."

In the long run Kern expects factor investing to "stand the test of time. But forward return premiums are likely to be somewhat lower than historical premiums."

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