by Maz Jadallah

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The very nature of making investment decisions is difficult – an investor can only evaluate an investment based on historical returns and/or credibility. Yet both of these attributes are poor predictors of what the investor is actually paying for – future performance. Combine this with the fact that there are nearly 30,000 investment products to select from, and it becomes clear why so many people are struggling with their investment decisions.

Let’s call this dilemma the “tyranny of choice” – too many stocks, funds, managers and strategies to evaluate all of them continuously for quality. To solve this dilemma, most investors rely on some form of advisor. In reality, choosing an advisor doesn’t solve the dilemma, it simply transfers it to someone else who will select an active or passive investment strategy (or combination of both).

Active strategies are a costly way to underperform.

Since the financial crisis, active strategies have gotten a bad rap – and for good reason. Most active strategies (usually in the form of a mutual fund or hedge fund) have underperformed their benchmark, and very few show consistent performance over time. According to the Standard & Poor’s Persistence Score Card published quarterly, only 5.28 percent of all active domestic equity funds managed to stay in the top quartile after three years. Add to that the fact that active strategies usually are more expensive than passive investment products, and it becomes clear why many investors are increasing wary of them.

Passive strategies fail to offer protection.

By contrast, passive strategies have become popular as they are much cheaper than their active counterparts and have shown solid performance, at least over the past five years. They’re also more accessible than active strategies, and they give investors the average returns of all securities in the market, for better or worse – herein lies the problem.

Most investors focus on the benefits of passive strategies and set aside the potential pitfalls. Investors look at past market returns and incorrectly assume prior performance will be replicated.  For example, expected returns for equities over the next decade are forecast to be, at best, half of the returns over the prior decade.  Most investors don’t focus on this at all.  They should – lower returns mean an investor will have to work longer, save more, or do with less during retirement. Like it or not, performance matters.

Perhaps even more importantly, passive strategies rarely employ active downside protection.  The conventional thinking is that simple asset class diversification is sufficient to protect your portfolio. Anyone who lived through 1987 or 2000/2001 or 2008 knows this is simply not true.  Asset class correlations increase to 1 (i.e. their prices move in tandem) during extreme market drawdown events.  Investing passively means you want the average return in the asset class you are investing.  To realize the average return over any period of time requires staying invested over the entire time period – a near impossible challenge when your portfolio is down 30 or 50 percent.

So, which is it? Pay a lot for the unlikely chance you’ll outperform the market, or pay next to nothing and get dismal market returns and no downside protection? Everything being equal, most investors focus on what they can control – fees.

A new approach that can help investors and their advisors cut through the noise? 

Enter SEC Form 13f-HR.  Institutional investors and hedge funds are required to disclose all their long positions quarterly to the SEC in Form 13F. The form allows any investor to view where a particular manager is investing and when analyzed properly can also give the investor a view of whether the manager has demonstrated any stock selection skill.

Evaluating a manager using his or her disclosures can be much more powerful than any due diligence of the manager’s actual returns. Think about it – a manager’s actual performance can come from many sources including the use of leverage, market timing, trading skill and of course the manager’s selection skill. This makes it practically impossible for most investors to identify exactly what has driven performance for the manager. On the other hand, “cloning” a manager’s holdings based on their filings strips away all potential sources of returns except the most important one – manager selection skill.

Analysis of institutional holdings via Form 13F can give investors an elegant way to solve the problems of access and manager selection in active investing. By offering these strategies in ETF form, investors can also benefit from the best of passive investing. ETFs – with their rules-based portfolio construction and hedging, transparency, relatively lower cost, accessibility and tax efficiency – can give investors material advantages over mutual funds, hedge funds or separate accounts. This new breed of “strategy ETFs” leverage the power of both man and machine to increase the potential for investors to achieve their investment goals. We call it “smart alpha.”

Think of the smart alpha approach as a self-driving car in the investment journey. It can drive, select and alter the route, and avoid risks on the road, in order to arrive at the destination safely, quickly and relatively cheaply. For the long-term investor, it can solve, once and for all, the tyranny of having to continuously select investment choices along their investment journey.

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