Morningstar Magazine - June/July 2018 - 92

Investors

generally invest in a lot of different securities that
have certain factor characteristics. Active
share is probably not the right measure to use
to distinguish among strategic-beta funds.
Looking at tracking errors, there's a wide diversity,
but I was struck by how large many of the
tracking errors are.
Inker: I'll throw in two points on strategic beta.
One is that, in general, you need a good backtest
to sell these strategies. There are a lot of
smart-beta ETFs-to our mind, more than there
are plausible sustainable factors that we would
expect to outperform over time. So there is a lot of
data mining. If you find something that has
outperformed historically, you can create an ETF
around it, whether or not it's a good idea.

In addition, their turnover and their transaction
costs differ. I would guess that correlates with
performance. A high-turnover strategy, particularly
one that delves into more expensive-to-trade
securities, is also more likely to underperform.
Which leads into my next question. In recent
years, I've periodically looked at concentrated actively
run mutual funds-those that have, say, fewer
than 50 holdings. Pretty consistently, they've
had high expenses. They have also tended
to underperform as a group, and by more than their
expense ratios.

Inker: I don't know what particular time periods
you're looking at, but for the past few years,
performance has been driven by a relatively small
number of large-cap names. The so-called
FAANGs have done very well versus the market.
In a situation like that, if you have a portfolio
of, let's say, 10 random stocks, you are really likely
to underperform. You might want to look
at these funds relative to an equal-weighted index.
They may have still done poorly, but it would
take out some of that skew.
Martijn, do you think this FAANG phenomenon is
part of what has lowered the results for the high active
share funds in recent years?

Cremers: In my studies, you generally need
to look at a long period of time before you find

I'm not surprised that we've seen relatively
better behavior, on average, among investors
in index funds.
Ben Johnson

any statistical significance, but it's a plausible
explanation. The last 10 years have been,
in general, difficult for active managers. It's partly
because the inflow into passive funds has
been so enormous. That has created headwinds for
active managers. At the same time, perhaps
this will lead to better opportunities in the future.
We published a study recently that found
evidence that active managers perform better in
environments with a lot of index fund competition.6 They become more active, so active shares
go up, and they also lower their fees.

We've talked about how active active managers should
be. How passive should index funds be? Will
strategic beta take business away from conventional
active managers?

Johnson: Maybe, to the extent that these
strategies can repackage active bets in a manner
that is less costly, eliminates certain idiosyncratic
risk, and could potentially be done in a more
tax-efficient manner.

That said, the laws of gravity, or the laws of active
management, still apply. Generally speaking, the

6 Cremers, M., Ferreira, M. Matos, P., & Starks, L. 2016, "Indexing and Active Fund Management: International Evidence." Journal of Financial Economics Vol. 120, No. 3, pp. 539-560.

Morningstar June/July 2018

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