"Smart" indexes that measure patterns and characteristics of the sharemarket are proving to be the best way for investors to actively manage their funds, according a leading US investment strategist.
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Craig Lazzara, a managing director at the New York-based McGraw Hill Financial, told an ANZ investment lunch in Melbourne this week a crucial factor in the effectiveness of active management had been the development of "smart beta".
These were indices such as the Standard and Poor's 500 Low Volatility Index that tracked a specific pattern or characteristic of the broader market.
Some of indexes had outperformed the broader market and had, in a sense, replaced the sophisticated strategies employed by active management of funds - with far greater success.
Since 1990, for example, the Standard and Poor's 500 Low Volatility index had outperformed the benchmark Standard and Poor's 500 Index by a considerable margin.
In other words, an investor who had simply followed the low volatility index would have gained a greater return than active managers - in most cases - as well as investors who had tracked the benchmark index.
The Low Volatility index has only been going since 2011 so the 1990-2011 comparison was hypothetical.
Is beta better?
Similarly, the Standard and Poor's Equal Weight index had also outperformed.
"Smart beta enables us to indicise sophisticated strategies, formerly available only via active management," he said.
In any event, active management had a long history of not being successful, he said.
"Most active managers fail most of the time," Mr Lazzara told the lunch. "Index investors have an above-average chance of above-average results. Asset owners should compare their active managers to index benchmarks."
In his presentation, titled "Is Active Management Getting Harder," Mr Lazzara noted that most - although not all - US and Australian Equity Funds had underperformed the index.
In the US investment space, 81 per cent of large cap-funds had underperformed the Standard and Poor's 500 over five years, he said.
Over the same period, 78 per cent of mid-cap funds had underperformed the Standard and Poor's MidCap 400, while 79 per cent of small cap funds had underperformed the Standard and Poor's SmallCap 600.
The results were better when measured over a one year period. Mid-cap funds actually outperformed the index. However, 65 per cent of large-cap funds and 59 per cent of small-cap funds did not.
Australia picture 'mixed'
In Australia, the picture was more mixed. Over 1 year, 53 per cent of Australian equity funds underperformed the ASX200, while over 5 years, 71 per cent of funds underperformed the index.
However, the picture was better for funds specialising in smaller to medium businesses. Over 1 year, 55 per cent of these funds underperformed the ASX mid-small cap index.
However, over five years only 29 per cent of small and mid-cap funds underperformed the ASX mid-small cap index. The majority of such funds outperformed the index.
Indeed, underperfomance of funds compared to simple tracking of the index was a global phenomenon, said Mr Lazzara.
Mr Lazzara compared 10 sharemarkets throughout the world - Australia, Japan, India, South Africa, Europe, Brazil, Chile, Mexico, the US and Canada - and the performance of funds versus indexes over 3 time periods - 1, 3 and 5 years.
Of the 30 comparisons, in only two did the index fail to outperform the funds. In India over 1 year, only 76 per cent of funds outperformed the index and in Chile, over the same time period, 53 per cent of funds outperformed the index.