Few topics raise the ire of money managers more than the benefits of active versus passive investing. And while this war continues unabated, passive investing is gaining the upper hand.

You see, roughly 20% of assets in the U.S. were in passive investments at the start of the financial crisis in 2007. That number grew to more than one-third by 2018. But in the next two years, passive investments will constitute more than half of all retail equity flows.

Clearly, the trend is towards passive investing — which begs the question, what is passive investing?

Passive Investing
Passive investing is a strategy in which a mutual fund or exchange-traded fund (ETF) buys securities that mimic a benchmark. That benchmark might be the market as a whole, such as the S&P 500 Index. But it could just as easily represent a subset of a broader market, such as the energy or health care sectors.

#-ad_banner-#In either case, the fund or ETF buys all of the stocks that make up its benchmark. The only portfolio turnover is when the index re-balances its underlying stocks. This allows investors to maximize returns over the long haul by limiting the fees associated with frequent trading.

And while it may seem counterintuitive, passive investing consistently beats the returns of actively managed funds and ETFs. In fact, it’s not even close.

Research shows that large-cap funds trying to outperform the S&P 500 benchmark failed more than 92% of the time from 2001 through 2016. The numbers were even worse for mid- and small-cap funds. Interestingly, results were only moderately better for so-called large-cap value funds — funds that look to buy stocks at a discount to their intrinsic value. For the same 15-year period, they failed to reach their benchmark 78.5% of the time.

But this doesn’t mean that passive investing is without its own set of problems.     

Top-Heavy Index
The problem with most index funds is that they are weighted on market capitalization (stock price multiplied by the number of outstanding shares). This means that index funds tend to become “top-heavy” with overpriced large-cap stocks. This is especially true when investor emotions drive short-term cycles.
You see, market-cap weighted indices purchase additional shares of a stock as that company’s stock rises. And buying additional shares of rising stocks means the fund is buying shares at lofty levels. So, funds end up laden with overpriced large-cap stocks.

This pattern played out in the internet bubble of the late 1990s. As internet stocks kept rising, market cap-weighted indices saw their concentrations to the tech sector rise disproportionately to the market as a whole. So, when tech stocks fell out of favor with investors, market cap weighted funds experienced declines greater than if they weighted their indices with factors other than market capitalization.

It’s also important to remember the opposite is also true. You see, as investors become pessimistic about a stock, that stock’s price falls. This reduces the company’s market capitalization and, in turn, the stock’s weighting in the index. Ultimately, the index owns fewer stocks priced at a discount to their intrinsic value. The irony here is that passive investors actually face greater diversification risk in a cap-weighted index fund.

But there are ways to mitigate these risks.

A Smarter Use of Beta
Building a portfolio that mitigates the risk of having too many overpriced large cap stocks should be the goal of every passive investor. But to accomplish this task, an investor must understand the basics of beta and the relationship between risk and reward.

Beta measures a stock’s volatility against a broad index, such as the S&P 500. A stock with a beta of 1 tends to move in concert with the broader market. But a stock with a beta greater than 1 will see greater volatility due to the increased risk.

As an example, let’s say a stock has a beta of 1.2. Should the market rise by 10 points, a stock with a beta of 1.2 would experience roughly a 12-point increase (20% more). Of course, if the market were to decrease by 10 points, the stock would decline by approximately 12 points.

A stock with a beta below 1 is less volatile than the market as a whole. For example, a stock with a beta of .80 would be 20% less volatile than the market. So if the market changes by 10 points, this lower beta stock should experience a roughly 8-point increase/decrease.

So, how can an investor use a smart beta strategy to mitigate the risk of traditional cap-weighted index funds?

Smart Beta
Smart beta investing combines the benefits of passive investing with the benefits of active investing. But it does so while reducing the risk of becoming top-heavy.

Smart beta funds accomplish this by weighting a portfolio with strategies that improve performance without significantly increasing beta. This gives managers the ability to purchase more shares with better fundamentals such as book value, sales, revenues, and cash flows.

Best of all, it works. Back-tested research shows that portfolios using these strategies out-perform passive funds by as much as 200 basis points — more than enough to offset the slightly higher fees.

Smart beta investing also gives managers the ability to weight a portfolio to value — one of my favorite metrics. Here, a manager buys more shares of stocks trading at rock-bottom prices and fewer shares trading at premiums. In back-tested research, this strategy provided a 600 basis point advantage over cap-weighted index funds.

And with results like these, the war between active and passive investors will soon become nothing more than a footnote in the history of finance.

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