WisdomTree: The Active vs. Passive Debate in Mid-Cap Equities

Why Indexes?

Like all investors, active managers are susceptible to behavioral biases that can negatively affect their investment decisions. This is illustrated through the table above, which shows that the majority of active managers actually underperformed their respective benchmarks over the most recent 10-year period and over the majority of calendar years.

For believers of active management, I think these results are even more alarming given the fact that the Russell and S&P indexes are market cap-weighted. Market cap-weighted indexes typically give the greatest weight to the stocks with the highest prices, without regard to any measure of fundamental value. As a result, the market capitalization-weighted index may tend to over-weight more expensive equities and under-weight those that may be relatively less expensive.

Why Smart Beta?

Although I do not feel active management is necessary to provide compelling long-term returns, I do think it is important to invest with a disciplined focus on valuations. WisdomTree uses a rules-based methodology to weight the companies in its Indexes by their underlying fundamentals, such as dividends or earnings, because at WisdomTree we believe that stock markets are not always efficient. Furthermore, WisdomTree rebalances its Indexes annually to adjust for relative value.

As I referenced above, although dispersion levels can’t predict active manager performance, the current low dispersion levels imply that there are potentially fewer opportunities for active managers than usual. Given this reading and the historical underperformance of active managers against traditional indexes, I do not think it is time for active management in mid-cap equities.

¹Sources: Zephyr StyleADVISOR, Morningstar; Index inception: 02/01/2007.