The controversy over smart-beta exchange-traded funds, or what we prefer to call “second-generation” passive investing strategies, continues to smolder as analysts and advisers argue over the value of the growing number of alternative approaches that claim to improve on traditional, first-generation passive indexes, like the S&P 500. The reason is obvious — billions of dollars are at stake, with the SPDR S&P 500 ETF (SPY) alone representing about $175 billion in assets as of late August.
The first generation of passive investing traces its roots back to the heyday of modern portfolio theory, which assumes that investors are rational and equity markets are efficient. If true, then the best portfolio in terms of risk and expected return (mean variance) is a “market portfolio.” The S&P 500 became the most popular proxy for a market portfolio, providing the foundation for the first generation of passive investing based on market capitalization.
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With the confluence of the tech bubble of the late 1990s and early 2000s and the growing influence of behavioral finance, which revealed the fallacy of the first requirement of MPT — investors are rational — people came to question the efficacy of passive investing. While certain attributes such as low cost may be valid, the line of thinking that existing passive strategies could be improved upon gave rise to the second generation of passive strategies.
ADDING VALUE
The debate now centers on whether it's possible to identify elements that can consistently add value relative to market capitalization-weighted passive strategies. In their current iterations, many second-generation passive strategies use either simplified skewing (equal weight, dividend emphasis, etc.) or multifactor analysis (including regression techniques) to construct their portfolios. These strategies generally depend on reported corporate financial data and as a result, are inherently backward looking. Further, because first-generation passive strategies also rely on current market price as an indicator of value, they can overweight overvalued securities and underweight those that may be undervalued.
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If you assume, as the behavioral finance crowd does, that all investors are not 100% rational 100% of the time — and, in fact, behave irrationally on occasion, then you open up the possibility of new approaches. One idea is to utilize an intrinsic value investment philosophy, which assumes that a company's fundamental economic value, or intrinsic value, is independent of its stock price and that intrinsic value can be reasonably estimated using a discounted cash flow methodology.
This approach builds on the assumption that markets can behave at times in irrational ways and that, as a result, the price of a company's stock can decouple from the intrinsic value of the business. The investment opportunity lies in the ability to identify opportunities where the current market price does not reflect a company's intrinsic value.
FORWARD LOOKING
With this methodology, correctly anticipating cash flows and applying the appropriate discount rate to determine intrinsic value is critical. If successful, the benefit is a forward-looking estimate of value, resulting in a process that tends to underweight those stocks that are overvalued and overweight those that are undervalued — the exact opposite of the approach of many market capitalization-weighted indexes. This positions the investor to take advantage of the demonstrated phenomenon of mean reversion, or the tendency of both high and low equity valuations to return toward the mean over time. Incorporating the mean reversion of capitalization rates is consistent with economic theory and can help correct for the natural human emotional tendencies identified by behavioral finance.
If the concept of intrinsic value has merit, an index based on this methodology should show enhanced returns relative to a comparable, market capitalization-weighted benchmark over some reasonable number of years.
We believe that the second generation of passive strategies now entering the market will not be the last. Since its advent in the 1950s, MPT has provided many tools for investors, but the world does not stand still, and the behaviorists too have much to add. As these and other insights find practical application in index-based products, we would expect to see a continued migration of assets to those strategies that demonstrate that the investment theory they embrace can deliver in practice.
Ric Dillon is the chief executive of Diamond Hill Capital Management, which has $16 billion in assets under management.
