Should You Replace Your Active Manager with a Smart Beta ETF?

By Joe Smith, CFA, CLS Investments

The rise of ETFs has generally come at the expense of active management, primarily via mutual funds. For years, active managers have been under fire as an increasing amount of research has determined that a manager’s performance is largely driven by a function of beta, or risk factors, rather than unique alpha.

BlackRock’s CEO Larry Fink summed this up well in a recent interview with Bloomberg noting, “One thing you have to understand related to the growth of ETFs is that a large component of the growth is not people seeking beta; it’s active managers navigating beta for alpha.” 

Smart beta ETFs aim to take passive investing one step further by applying a rules-based approach to replicate decisions made by active managers. This has certainly been true with the rise of multi-factor ETFs such as LRGF, TILT, GSLC, JPUS, and JHML, just to name a few.

So, investors are now facing a simple question, — should you replace your active manager with a smart beta ETF?  To better understand this, we’ve studied the weekly performance of U.S. equity active mutual funds and their smart beta ETF peers in each Morningstar style box category. We evaluate funds with inception dates at least three years prior, and with performance history from 12/29/13 through 4/8/2017.

The Classic View to Identifying Winners and Losers

Performance by active mutual fund managers and smart beta ETFs can have striking differences and similarities depending on their general classification. According to our collected data, the average percentage of managers who successfully outperformed their respective style benchmarks is only 19% across all Morningstar categories considered. This compares with the roughly 40% of smart beta ETFs that outperformed their style benchmarks during the time period considered. Many would argue this window is not a true indication of an active manager’s ability to outperform over a full market cycle given it only assesses each fund’s performance for the past three years. But, this window was selected to account for the fact that many smart beta ETFs launched over the last few years.

Regardless, it may be more important to evaluate the degree of consistency with a fund’s outperformance, not just whether an active mutual fund manager or smart beta ETF beat its benchmark over a given time period.

An Alternative View to Identifying Winners and Losers

Another way to evaluate the degree of consistency and skill or edge associated with an active mutual fund manager or smart beta ETF is to determine whether their outperformance is a function of their investment process, or simply just luck.

For our study, we focused on weekly observations of relative performance to answer a simple question, “Did the active mutual fund manager or smart beta ETF outperform its style benchmark or not?” We set out prior beliefs about the chances for each to outperform in a given week to be distributed around 50% (with some variation to account for the uncertainty of their true chances to outperform). Active mutual fund managers and smart beta ETFs whose chances to outperform are greater than 50% in any one week should reflect some amount of skill/edge relative to their peers, and vice versa.

Each week of out- or underperformance is generally independent and binomial in nature. So we can adjust our prior beliefs regarding a fund or ETF’s chances to outperform based on the actual instances of outperformance (as illustrated in the chart below). For example, FVD’s adjusted chances for outperforming its style benchmark (the Russell 1000 Value Index) were estimated to be about 54% after accounting for the fact it beat its style benchmark 96 out of the 171 weeks considered.

Do the Odds Favor Your Active Fund or Smart Beta ETF’s Ability to Outperform?

So, what do our results show? In general, across all categories, there is a lower percentage of active mutual fund managers and smart beta ETFs whose chances to outperform their style benchmarks are greater than 50%. This averages out to about 10% of active mutual fund managers across each Morningstar category and 17% of all smart beta ETFs in the same categories. The exceptions that we observed for smart beta ETFs were in the U.S. mid-cap blend and U.S. small-cap growth categories. In those categories, no smart beta ETFs were identified as having a greater than 50% chance of outperforming their style benchmarks in a given week.

We also observed the average excess returns of the active mutual funds and smart beta ETFs identified as having greater chances to outperform were similar, but varied based on each Morningstar category. In most cases, excess returns were slightly higher for smart beta ETFs in certain Morningstar categories as compared to their active mutual fund peers.

 The Key Takeaway for Investors

Based on our study, the evidence is not necessarily conclusive as to whether active mutual funds or smart beta ETFs have a distinct edge over each other. However, the data does show signs that some smart beta ETFs have slightly higher chances on average to outperform their style benchmarks than their active manager peer in the same style category.

The key point investors should take away is that skill/edge is not just a function of an investment style, but rather the degree of consistency any fund (active or smart beta) has in repeating its process over time. As with anything, further evaluation and data will help our beliefs evolve. Only time will tell which approach will be more beneficial for investors.

Joe Smith, CFA, is a Senior Market Strategist at CLS Investments, a participant in the ETF Strategist Channel.

Disclosure Information

This information is prepared for general information only.  Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such.  All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only.  No graph or chart should be regarded as a guide to investing.

2506-CLS-4/28/2017