A senior manager at a passive fund management firm noticed a younger colleague doing something he shouldn't be. The senior manager yelled at the junior colleague, "Don't just do something—sit there!"
This is a joke active fund managers tell about passive fund managers. It isn’t all that funny, but it betrays a common misconception about passive management.
Rather than passive fund managers just sitting there not doing anything, much of the innovation within financial services comes from this segment of the industry. This innovation gives investors new choices and opportunities. Investors now have cost effective access to ‘passive’ tools that can outperform the markets something they have traditionally paid more expensive active managers to do.
The world of passive investing is far from just sitting there.
As you know an active manager’s job is to beat a fund’s benchmark index. If the index returns 10%, they are aiming to return more than 10%. If the index falls 10%, they are aiming not to fall as far as 10%. Most active managers use a market capitalisation index as the benchmark they are trying to beat. Active manager’s call their outperformance ‘alpha’. They refer to the performance of the index or the market, as ‘beta’.
Beta is also used as a term to measure correlation, in this instance the correlation to the market benchmark. The benchmark in international equities for example would be the MSCI World ex Australia Index and the index would have a beta of 1. A fund manager with a beta less than 1 would experience smaller price movements than the MSCI World ex Australia Index. Conversely, a beta higher than 1 would have bigger price movements than the MSCI World ex Australia Index.
The very first exchange traded funds, or ETFs, tracked traditional market capitalisation benchmark indices and were seen as tools for beta exposure. Their portfolios had betas of 1. Investors soon started to question whether these benchmarks made for good investment portfolios. One of the early challenges was to the use of market capitalisation weights. An ETF which tracks a market capitalisation index allocates more to bigger companies than smaller companies. So when the market overvalues a stock, a fund tracking that index buys too much of the overpriced stock. Conversely when the market undervalues a stock, the fund sells too much of the underpriced stock. For investors seeking maximum returns, this is not ideal.
Index providers reacted, creating indices that targeted better returns than the traditional benchmark, for example, by capping the weighting for larger companies or even equal weighting the portfolio. These innovative index construction techniques became known as ‘smart beta’. As with most jargon, the definition of smart beta has been hijacked. There is no agreed industry consensus as to what smart beta actually means. Some define smart beta as any type of index that is not market capitalisation-weighted. Others define it as investments that apply screening techniques or use company data to narrow the portfolio or adjust weightings in existing indices.
Either way ‘smart beta’ can be thought of the intersection of active management and passive investing. It has the intention to outperform the market using data techniques in place of active managers’ judgement to select and weight stocks.
Australian institutional investors have been employing smart beta strategies to achieve outperformance, or alpha, relative to market capitalisation benchmark indices for some time. Smart beta strategies have taken off globally with over $US65bn of inflows during 2013 being allocated to smart beta ETFs (source: Blackrock).
MSCI, the world’s largest index provider has been at the forefront of this innovation. MSCI has created a smart beta index that is the basis for the first smart beta international equity ETF on the ASX - the Market Vectors MSCI World ex Australia Quality ETF (ASX code: QUAL).
MSCI analyses the data for the stocks in its MSCI World ex Australia Index and identifies those companies with the strongest investment fundamentals for inclusion in its Market Vectors MSCI World ex Australia Quality Index. MSCI selects the highest scoring companies comprising the top 30% of its MSCI World ex Australia Index. MSCI Quality scores are based on three fundamental factors:
- return on equity;
- earnings variability; and
- debt-to-equity ratio.
There is more to passive investing than just sitting there.
QUAL is the only smart beta international ETF on the ASX. It is an ideal International equity portfolio providing access to 300 of the highest quality international companies in a single trade on the ASX. The MSCI World ex Australia Quality Index can demonstrate historical outperformance against its parent, the standard international, MSCI World ex Australia Index.