We all know that as far as asset management goes, "Active" is out and "Passive"

ref :- "Smart beta funds eye $1trn milestone in race for cash" , The Financial Times, Companies and Markets.

Those brought up in a Britain of a million years ago might have sepia-tinged memories of the "Janet and John" books, (that wasn't sepia, it was smog). For those who weren't, which is to say almost everybody, the "Janet and John" series were early-learning picture books aimed squarely at 4 - 7 year olds. We reminisce in this way because if there are those out there getting a bit twitchy at the mere mention of terms like "Smart Beta", they can rest easy ..... we shall be taking the "Janet and John" approach to any required definitions or explanations ...... not least because in this, as in life itself, it suits us just fine.

One definition of Active Investing is a portfolio management policy that has an asset manager making specific investment decisions with the goal of outperforming an investment benchmark index -- say the S&P 500, or the FTSE 100.

Passive Investors, on the other hand, expect a return that closely (or even entirely) replicates the investment weighting and returns of that benchmark index. So much so that the investment itself will often take the form of a simple index-tracking fund.

Back in the days when thanks to Tom Wolfe and his Bonfire of the Vanities, "Masters of the Universe" was taken to refer to all-conquering Wall St. traders rather than the Mattel comic and film franchise, all the buzz was about Active fund management. Managers of aggressive and sometimes highly-leveraged Hedge Funds were able, amid great fanfare, to earn spectacular returns for clients and some enormous paycheques for themselves. Of course there was little or no fanfare about all the hedge funds that failed, or even about the more cautious and lower-profile funds that made up the majority of the sector. Nevertheless, active management was very much in vogue.

Recent years of course has seen a change in momentum with regard to what type of portfolios investors want. With stock indices marching ever higher (since 2009 in the case of the S&P 500, say), the returns on simple, index-tracking "passive" strategies have outstripped those offered by the majority of active managers, who in many cases have struggled to keep their P & Ls in the black. There's a suggestion that factors like the distortion of markets by super-easy monetary policies (QE, etc), and the unpredictability of political developments (not to mention the breakdown of their expected effects on markets) have contributed heavily to the difficulties being experienced by discretionary stock-pickers and trading advisors.

And it's not only in terms of performance that passive investment has it over the active alternative these days. Tougher regulation is a factor, but more importantly difficult times caused investors to focus on the much higher fees incurred in an actively managed portfolio. If one strategy is beating the other in terms of both profitability and costs, it shouldn't be a surprise that more and more money has been switched in that direction.

Anyway, an analysis of data released by Morningstar on the subject of assets under management in different types of funds reveals that if active management is the ailing giant ceding ground to its up-and-coming passive cousin, the fastest growing area is in fact Smart Beta funds, which could be described as a hybrid of the two or probably more accurately as "Passive with a Tweak."

Which is to say, smart beta funds take a basic passive investment strategy which replicates a particular index and adapts it in the attempt to maximise returns. The nature of that adaptation varies, but it may alter the standard weightings within the index in the search for cheaper stocks or those with greater momentum, for example. It may take into account such factors as liquidity, quality and volatility.

Whatever the case, investors seem to like the combination of an active investment element applied to a comparatively well-defined trading strategy, all combined with much cheaper fees. Assets under management in smart beta funds have risen by 207% over 5 years, and by the end of this year the total figure is projected to break through the $1 trn barrier. That compares to growth in non-beta funds of 121% over the same period (now at $6.8 trn), and in active funds of 35% to $26 trn.

All of which is very interesting and if stock indices keep up their steady advances into new record territories, one might expect the trend to continue. But even Rob Arnott, the so-called godfather of smart beta, warned last year that things could go "horribly wrong". As the FT points out there are concerns that analysis underpinning the strategies is not rigorous enough and that investors are piling into these funds at a time when their performance could decline. One of the problems with these vehicles is that price is the measure of performance, rather than taking much account of things like dividends, say. The search for performance means that price rises can be self-fulfilling as more investors pile in, but prices can lose touch with the basic fundamentals needed to sustain them. That can manifest itself in some serious overvaluations.

Still, arguably you could say something similar about much of the market as a whole. For now, the trend towards these (comparatively) new products is intact. But trends can change as market dynamics change. If the markets suffer a dramatic decline, funds that track indices even if they have been tweaked will suffer along with them. Those are the times when you might want active managers ..... they'llneed to be pretty good at it, though.

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