How to combine the best of passive and active investing for your portfolio

A common criticism of passive investing is that you are simply blindly following the market, whether it rises or falls. What if it could be more? What if you could be more targeted, weaponised in how you invested with passive investments?

The answer could be the modernised form of indexing, known as smart-beta.

Unlike traditional indices, which select companies by size or market capitalisation, smart-beta weights investments differently.

“You can have indices that select and weight companies not just based on size, but on other elements as well,” says Betashares’ Tom Wickenden.

“You can think about factors, you can think about equal weighting, even within fixed income, there can be different elements, like looking for potential future returns to select what securities you hold.”

Smart-beta is still passive investing, in that it is investing done automatically on the basis of set rules, but it is more tailored.

“Typically, they’re aiming to enhance returns or to reduce risk,” says Wickenden.

Why choose smart-beta?

Smart-beta can allow investors to select concerns to manage in their portfolios.

“Performance can be one reason to use smart-beta indices, but there are other reasons as well,” says Wickenden.

He shares the example of a smart-beta approach where companies are equally weighted, rather than by size, which can offer diversification if the traditional index is heavily weighted towards a few names or a particular sector.

“A smart-beta index can be used in that instance to reduce risk,” he says.

Appreciating risk and smart-beta

While smart-beta approaches can aim to enhance returns or to manage risks depending on their tailoring, that’s not to say they are without risks.

Wickenden points out that factors can underperform in certain environments, or that different indices may have different approaches to evaluating a factor like quality.

“You can’t just use a set-and-forget method of investing,” he says, encouraging investors to do their research and really understand how a smart-beta index selects companies and weights them.

And as he reminds us, “past performance isn’t an indicator of future performance.”

The most popular factor

When it comes to smart-beta factors, Wickenden notes that quality has been a standout in terms of popularity.

“Over the past five and 10 years, quality as a factor has performed really well. It’s almost defied some fundamental market principles. 

You’d expect that these companies are high earners consistently, they might be priced really expensively, but over the past five or 10 years, their price performance and their earnings have continued to grow quite steadily,” Wickenden says.

One example of a smart-beta approach to quality is Betashares Australian Quality ETF (ASX: AQLT) which uses screening to select and weight companies based on profitability, earnings stability, debt-to-equity levels or their leverage. It currently holds 40 companies, with names such as Wisetech (ASX: WTC), Resmed (ASX: RMD), Pro Medicus (ASX: PME), Hub24 (ASX: HUB) and Netwealth (ASX: NWL) featuring. It still holds big banks like Commonwealth Bank (ASX: CBA), but at much lower weightings compared to the ASX200.

ETF

Betashares Australian Quality ETF (AQLT)

Australian Shares

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The big risks in the market environment and managing it with equal-weight

If we think about the biggest market themes of the past two years, big tech and AI have been the standout, driving the bulk of returns. That in itself is something to be concerned about – we’re seeing high concentration.

“The top five names in the S&P 500, you’ve got a 25% weight in those names. The bottom 400 companies in the S&P 500, you’ve also got a 25% weight in them,” says Wickenden.

It means that the top five names have an extraordinary influence over market performance – whether it rises or falls.

In this situation, Wickenden says equal-weight approaches can be valuable.

“In the short term, equal-weight indices tend to outperform when market concentration is high and subsiding,” he says, adding that in a lot of markets, such an approach can outperform in the long term as well.

It can reduce the risk of larger companies unduly weighing on performance, and allows smaller companies to equally contribute to overall performance.

As an example, consider Betashares S&P 500 Equal Weight ETF (ASX: QUS). 

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Betashares Australian Quality ETF (AQLT)

Australian Shares

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If you base the average market cap on the market capitalisation weighting, you're giving undue weight to larger companies which would make the average appear higher, while if you base the average giving equal weighting to each company, the average will be lower (and likely more reflective of all the companies in the index, rather than just the top 5-10).

“The average market cap of the S&P 500 is actually that same number, $1 trillion. Even though nine companies have historically only ever reached that market, those large companies are so big in the index now, they’ve drawn the whole index weight up to close to $1 trillion. Whereas the equal weight, it’s closer to $100 billion,” says Wickenden.

It’s certainly something to think about, whether a broad index really represents the market.

Watch the video

To find out more about smart-beta investing and Betashares’ approach using quality and equal-weight options, make sure to watch the video. Wickenden shares the case for smart-beta and the risks involved, as well as discusses the concentration risk in markets.

Timestamps

Smart-beta investing

• 0:00 – Introduction and what is smart-beta investing
• 1:25 – Examples of smart-beta investing
• 3:45 – Most popular factors
• 5:05 – Risks of smart-beta investing

Australian example of smart beta: AQLT

• 6:50 – What does AQLT offer investors
• 7:55 – Myth busting: the lack of quality on the ASX
• 9:25 – Quality names on the ASX

Global example of smart beta: QUS

• 10:35 – The case for using an equal-weight strategy
• 11:34 – When does equal-weight outperform
• 13:20 – Rebalancing and tax implications
• 13:53 – Examples of the differences between S&P 500 and an equal-weight strategy