Vanguard: smart beta belongs firmly in the active category

Active passive roadsignsInvestment firm Vanguard has put smart beta firmly in the active camp, in delivering its white paper on the method of investing.

This is not to say that one of the largest providers of passive investment strategies is against the strategy - after all it has a large suite of actively managed products itself.

However, the firm says that the significant losses by large cap and growth stocks during the 2000 to 2002 bear market have led investors to seek a move away from standard market capitalisation weighted indices.

This hunt for other options included alternative indexing, fundamental indexing and the strategy du jour - smart beta. The firm believes strongly that, by definition, smart-beta indices should be considered rules-based active strategies because their methodologies tend to generate meaningful security-level deviations, or tracking errors, versus a broad market-cap index.

The paper explains that in non-market-cap weighted indices, the decision to deviate from market weights occurs before, rather than during, the portfolio implementation process. This means that although not active in the traditional sense, the index provider’s decision to select and assign weights to securities reflects a primary component of active risk.

Vanguard’s view is likely to attract critics; many exchange-traded fund providers use smart beta and categorise their products as passive. However, the firm does not think the word ‘beta’ should even be used in this investment strategy, because the weightings of smart beta products differ meaningfully from market capitalisation and therefore do not represent an asset class.

The report states: “we believe that smart- beta strategies are best thought of as active investment strategies.”

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