Active or Passive? Yes, Exactly.

The Wall Street Journal ran an interesting article over the weekend entitled, ‘Three Things to Know About Smart Beta.’  You can find the article here, but you may need a subscription.

Before diving into the article, the first thing you should know is that smart beta is the marketing term for tilting your portfolio towards factors like sizevalue, momentum and quality.

We call this factor investing, but there are tons of names in the market like Sensible Beta, Strategy Beta, Scientific Beta, Alternative Beta and now, from Goldman Sachs, Active Beta.

None of these terms are wrong, I just want to point out that if you read Daily Insights, you already know what smart beta is, just not by this name (although I did cover the nomenclature here last September).

The first thing to know according to the Wall Street Journal is that all factors go through good and bad periods, over and underperformance.  This shouldn’t be news to you either based on several articles I’ve written before (here and here), but it’s a fact that bears mentioning again (in fact, I wish the author had put more emphasis on this idea.

The second thing investors should know is that these funds, including the ones we own, have short-term sector risks embedded in them.  The classic example that’s more relevant today than ever, is that a value portfolio has a lot of energy exposure.

Energy stocks are subject to highly volatile commodity prices and since everyone knows that they can get their teeth kicked in like this year, they tend to trade at lower multiples than other sectors.

The third thing the Journal mentions is that active management can creep in to smart beta.  This is so important that it’s actually what caused me to write this article.

There are some people in our industry who write about ‘active’ and ‘passive’ as if they are black and white, but in reality there is a wide spectrum between active and passive, and most everyone falls somewhere in the middle – even many of the active funds that end up looking a lot like their passive benchmarks.  (I wish we used different words incidentally, as  noted here).

I often like to put ideas on a scale of one to ten because everyone understands the basic idea.  So I would say that if perfectly active was a one on the scale and passive was a 10, Acropolis would fall somewhere between seven and eight.

That’s not very scientific, but it’s about right and that’s what I’m aiming for.  In that vein, I like the Warren Buffett quote where he says ‘you don’t have to know a man’s exact weight to know that he’s fat.’