Are Strategic Beta ETFs a Threat to Active Fund Managers?

Note: This article is part of Morningstar's April 2015 Active, Passive, and In-Between special report. A version of this article ran on Morningstar.com on Jan. 17, 2015.

Strategic beta, more commonly known as "smart beta," is all the rage at the moment. Everyone in the ETF world talks about it and new products carrying the label launch almost every week.

Investors are buying into the concept, too. Designed to either improve return or alter risk relative to traditional market-capitalization-weighted indexes by using factor tilts, strategic beta indexes are garnering assets. By the end of 2014, more than $400 billion was invested in strategic-beta ETFs, representing a significant chunk of the $2 trillion ETF market.

Some see the increasing popularity of strategic beta ETFs as a competitive threat to traditional index investing. They argue that market-cap-weighted indexes are inherently flawed and reckon that, as passive investors become progressively accepting of this fact, they will seek "smarter" ways of building portfolios, based on systematic risk factors.

I disagree. In my view, investors wishing to be exposed to the broad market will continue to favor market-cap weighted indexes as these will always be the best representation of the market. Rather, I believe strategic beta ETFs could pose a serious threat to active managers, especially those who charge high fees for little added value, or "alpha."

Traditionally, portfolio returns have been decomposed into beta and alpha. Beta is the return of the broad market, while alpha--which one hopes is positive--is what's left over; unexplained and often interpreted as evidence of the manager's skill.

Over the past decade or so, with the help of academic research, investors' perception of what "alpha" truly represents has evolved. Many have come to the realization that a portion of what is considered "alpha" can be easily explained by market factors such as value, size, or momentum, thus leaving a smaller-than-thought portion of a portfolio return attributable to active management such as picking securities.

If this is so, then why not cut out the middle man and own the factors directly? This is a question that some large institutional investors have begun asking themselves. The Government Pension Fund of Norway--the biggest pension fund in Europe--and CalPERS--the biggest public pension fund in the U.S.--have both embraced the passive risk-factor-based view of the world. Individual investors and advisors should consider whether they should, too.

I believe that active fund managers who mostly load up on factors don't deserve to charge high fees. There are now plenty of low-cost, transparent, and formulaic factor-mimicking funds--predominantly ETFs--to choose from, with more coming down the pipeline.

For traditional active fund managers, the implications of the evolution of index investing and, in particular, the rise in popularity of strategic beta ETFs are twofold. First, they have clearly raised the bar. Indeed, a truly skilled manager will now have to demonstrate that he can outperform after deducting the influence of easily measurable factor exposures. Many studies show that once this deduction is made, evidence of managers' skill becomes really hard to detect, leading these researchers to conclude that skilled managers are exceedingly rare.

Second, if the active manager's returns are mostly the result of a combination of passive factor tilts, then there is little justification for commanding high fees. With that in mind, active managers are set to face ever-increasing pressures to demonstrate their merit.

This article was originally published in Investment Adviser magazine.