By Jan Erik Wärneryd, Optimum Quantvest Corporation

In recent years, there has been a lot of discussion in the investor community about the relative merits of active versus passive strategies. The current consensus among those who favor the passive (indexing) side appears to be that active managers charge high fees while they (mostly) fail to beat the market over time. Those who favor active management would say that the indices, particularly cap-weighted ones, are flawed and that stock-pickers can outperform them by finding the best companies.

An alternative to both strategies is what’s commonly called Smart Beta investing, which seeks to put together better portfolios that still own all or most of the names in the underlying indices but weigh them differently. A subset  of  Smart Beta strategies use “factor tilts” to establish portfolios that outperform over time by emphasizing  compensated factors such as size, value or momentum. This is based on the belief that some attributes of stocks (factors) will give investors higher returns than a pure index portfolio.

Most investors tend to think in terms of the broad categories active, passive and Smart Beta as distinct investment approaches without realizing how they are related. Active strategies are generally thought of as focused on stock-picking, i.e. finding good stocks where the portfolio manager thinks there is potential to outperform the underlying index. This tends to result in more concentrated portfolios that often represent a style of investing such as “growth investing” or “value investing”. To the portfolio manager, the focus is on finding stocks that meet certain criteria before doing a deeper analysis and finally selecting individual names for inclusion in the portfolio. The screening criteria could be earnings growth, P/E or Dividend yield, for example.

Another way of looking at this stage of the stock picking process is to say that portfolio managers are using factors to screen for potential investments. A growth investor may be looking for stocks that have high momentum or quality factors, for example. A value investor is presumably screening for stocks with high exposure to the value factor. These investors may not be thinking in factor terms, but factor investing is part of their process. In other words, these investors have already decided which factors are attractive and have narrowed down the universe of stocks they will consider accordingly. Within the subset of stocks they consider there will be significant exposure to whatever factor was used to define their investable universe in the first place, which isn’t that different from what a pure factor strategy would look like. The difference would be that the stock-picker, as opposed to the factor investor, looks at individual companies and seeks to add value by picking the best stocks within their universe, assuming that the individual stocks are the source of performance.

The factor investor, on the other hand, believes it is the factor exposure that gives the performance. He or she is not doing research on individual stocks that meet the factor criteria but is content to own all the stocks in that universe. In the example of the Value investor, he or she is implicitly saying that an investor needs to pick the right factor (Value) and the right stocks within the Value category to outperform the market. The Value factor investor says that it is enough to choose the factor rather than pick individual stocks. The ultimate strategy using this approach is of course to just own every stock in the index, which would be 100% passive. Factor investors believe that value can be added by focusing on the stocks that exhibit certain pre-determined attributes such as being cheaper than the market (Value), less volatile or exhibiting strong price momentum, rather than investing in the whole market.

So what we see from the above is that there is a continuum from passive to active investing; rather than being two distinct approaches, investors can apply aspects of both indexing and stock-picking to find where they think they can add value in the investing process. The passive/active approach can be further modified through for example sector investing, where a portfolio manager weighs sectors differently than the index based on sector attributes, which can be related to factors or macroeconomic forecasts. In our experience, the “sweet spot” for the return vs. fees trade off seems to be to focus on factors rather than stock-picking; investors may benefit from higher long term returns from the right factors for low incremental fees without taking the risks associated with stock-picking.

This article was written by Jan Erik Wärneryd, senior portfolio manager at Optimum Quantvest Corporation, a participant in the ETF Strategist Channel.

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