But the focus on cost reduction and just trying to duplicate an index can lead investors into the stupor of forgetting the risk factors as they put portfolios on a passive autopilot, Bernstein warns. Some view it as just another example of how the average retail investor follows the latest shiny object and ends up with poor returns.
Brightman of Research Affiliates endorses pactive investing as one of the ways that advisors can reduce risk. “Yes, the reason why smart beta was developed was the horrible experience that people had with passive investing in the aftermath of the tech bubble,” Brightman says.
He adds that those who had passively invested in a capitalization-weighted index “lost enormous amounts of their wealth.” However, those using smart beta “didn’t lose money.” Brightman also finds parallels between today’s market conditions and the euphoria of the late 1990s.
If another crash comes, Morningstar’s Johnson says that pactive investing will be on trial because the active management of passive investing will be on trial. “We have no way [of knowing] whether the portfolio manager you have recruited to help you avoid any nastiness that would be associated with any downdraft in the market will be successful,” Johnson says.
“The laws of active management still apply,” he adds, “irrespective of whether or not the instrument you are holding in your portfolio are index ETF funds or individual stocks or bonds or some combination of all of the above.”
Bernstein disagrees, and told Financial Advisor that his firm “managed to completely avoid the energy debacle in 2014.” He added, “Our portfolios are currently positioned to avoid a significant fixed-income bear market. I guess we’ll see if that works, but so far it seems to be working well.”