≡ Menu

Decision time: Market cap trackers, factor bets – or is Smart Beta better?

Some critics of passive investing say there’s “no such thing” as truly passive investing. They point out that even an investor who only uses index tracker funds has to decide:

  •  Which indices / trackers are the best in each class.
  • How and when to rebalance their portfolios.

That’s all true enough (especially the last one).

After all, Monevator is a site mostly about unwrapping the mysteries of passive investing. If such investing was utterly without nuance, we could have saved ourselves 1,000-odd articles over the past seven years!

But so what?

For every decision you need to make as a passive investor, someone else is making dozens if not hundreds as an active investor – almost by definition.

An active investor complaining that passive investing involves a lot of tricky decisions is like an air traffic controller being befuddled by a zebra crossing.

Moreover passive investing can be as complex or as simple as you want it to be.

My standard advice to new investors has long been to put half their monthly savings into a high interest savings account and to invest the other half into a broad index tracker fund. Do that in an ISA or SIPP, repeat for 30 years, evolve as you learn more, and I’m confident you’ll get a good result.

You could even use a Vanguard LifeStrategy fund and skip the cash bit.

Is it the perfect passive strategy? Probably not, but it’s super easy-to-implement, logic is on its side, and it’s inordinately easier than implementing an active strategy over 30 years – never mind actually beating the market by doing so.

Market cap trackers are just fine

That’s all a long-winded way of saying that straying from a bog-standard basket of market cap weighted index tracker funds is decidedly optional.

Indeed, our current view around here is that there’s no magic in Smart Beta or equal-weighted indices. You’re simply taking on more risk for hopefully more reward, and in most cases you’ll also face a headwind of higher costs for doing so.

And while we’re all for considering tilting your portfolio towards value shares or small caps, we’ve stressed such factor bets are no slam dunk to outperformance.

As such, they can safely be left in the ‘too hard’ pile if you want without any danger or feelings of foolishness.

You see, even the experts don’t agree about these issues, as this latest video from Sensible Investing reveals:

As the Nobel Prize-winning economist Professor Eugene Fama says:

“The overall cap-weight market portfolio – including everything, not just stocks – model is always a legitimate portfolio.

In any asset-pricing model it’s always one of the so-called efficient portfolios.

But if you take, for example, our work seriously, what it says is there are multiple dimensions of risk and you can tilt towards these dimensions, so you can move away from the market portfolio towards these dimensions.”

In other words, start with the simplest, broadest vanilla trackers, and then research and invest where your passion takes you – and if that’s to the conclusion that simple is best after all, then that is absolutely a-okay.

Check out the rest of the videos in this series so far.

Receive my articles for free in your inbox. Type your email and press submit:

{ 14 comments… add one }
  • 1 Rob October 9, 2014, 1:09 pm

    You say smart beta is higher risk than cap weighted portfolios and that they suffer higher costs. The cost issue is more about scale than process.

    Risk is measured by the deviation from the cap weighted index and allocations. That is more academic than practical. Many of us recall that market indices at the turn of the century were stuffed full of tech shares that didn’t make any money.

    Similarly, in the last 5 years since the crash, and QE, we have seen the FTSE 250 index increase by 180% while the FTSE 100 is “only” up 94%. Clearly, cheap capital has been attracted to companies that are deemed to riskier by size. That can be seen in the overall tilt of the market too where growth shares have outperformed blue chips, Barratt Developments is up twice as much as GSK. That is why the 250 yields 3.3% while the 100 yields 4.8%. Which is riskier?
    That is also why smart beta, which tends to favour value, has underperformed cap in the rally. But does that mean they are really riskier than cap weighted funds, or just more cautious?

  • 2 kean October 9, 2014, 1:10 pm

    Great bite size lesson once again, thanks you 🙂

    Passive involves decision making – Dah! Getting up in the morning & what will I have for breakfast involves decision making. Doesn’t everything in life e.g where to cross a road.

    To me the difference between passive & active investing is that in Passive the WHERE TO INVEST is completely nailed before I handover my dosh whereas Active involves banking on someone else’s (i,e fund analyst/manager’s) judgement. Like any human they’ll mis-judge at times.

    Then with beta passive it’s just shades of Grey i.e. whether I will eliminate choice of a cooked breakfast as a primary decision for example.

  • 3 qpop October 9, 2014, 2:15 pm

    You mention the ISA vs SIPPs article in your pre-amble. There is an interesting article on the Torygraph’s website about that debate, following the new rules:

    http://www.telegraph.co.uk/finance/personalfinance/pensions/11145410/Pensions-vs-Isas-the-tables-that-show-which-is-the-better-place-to-save.html

    They paint ISAs to be a SIPP’s poorer brother. I’d be interested to see how this tallies with your maths.

  • 4 ermine October 9, 2014, 2:23 pm

    My standard advice to new investors has long been to put half their monthly savings into a high interest savings account and to invest the other half into a broad index tracker fund. Do that in an ISA or SIPP, repeat for 30 years, evolve as you learn more, and I’m confident you’ll get a good result.

    I read that as always put half of savings in cash and half in equities, for 30-40 years, is that really what you mean? Agreed an eminently sensible split at the start, but once that cash fund is a year’s worth of essential expenses surely it’s time for easing back on the cash part and upping the equities section? Unless the cash is targeted at other short-term asset classes (eg house deposit within 5 years)

    @qpop I think TA said something similar here to the Torygraph

  • 5 qpop October 9, 2014, 2:37 pm

    @ermine I’m pretty sure Markowitz (the father of modern portfolio theory) mentioned in an interview that he had always invested in a 60/40 equity/bond portfolio, as his fear about regretting being wrong was enough to stop him seeking the efficient frontier (that sounds like a quote from Star Trek!)

  • 6 ermine October 9, 2014, 3:04 pm

    @qpop aha – maybe I just read wrongly. I wouldn’t have that much issue if what I interpreted as cash were bonds, maybe I was reading just too literally. It’s the thought of cash being held as cash across 30 or 40 long years that gives me the shivers! it’s hard to argue with a straight VGLS50:50 election.

  • 7 The Investor October 9, 2014, 7:15 pm

    @ermine — I don’t want to have the ‘returns from cash’ argument with you again. 🙂 It was quite possible to achieve a yield roughly as high from government bonds as a UK saver from high interest cash prior to the financial crisis, until you had at least a six-figure cash pot at least. It’s possibly possible now. Cash is a much better asset class for private investors than it is for institutions.

    But yes, I don’t mean just do that for 30 years necessarily (though I don’t think it’d be a disaster) hence the “as you evolve”. 🙂

    Bonds would be fine though, too.

    The point of the advice is to get people going. The point of the mention in the article was not to add a 500-word footnote. 😉

  • 8 dearieme October 9, 2014, 8:45 pm

    Two alpacas.

  • 9 Greg October 10, 2014, 1:21 am

    I’m going to keep my eye on the momentum factor ETF from iShares:
    http://citywire.co.uk/money/ishares-launches-etfs-for-different-styles-of-investment/a776338?ref=citywire-money-latest-news-list

    (Not that I’ve actually dipped my toe in. I have been keeping an eye on various non-cap weighted ETFs for a while, and I think the idea is sound, but it takes more than a vague feeling to convince me!)

  • 10 Lorenzo October 10, 2014, 11:54 am

    Can anyone provide me with an example of a smart beta tracker?

  • 11 The Rhino October 10, 2014, 12:41 pm

    err.. the link from greg directly above?

  • 12 Lorenzo October 10, 2014, 1:19 pm

    I do not really like ETFs, is there any good fund, maybe from Vanguard?

  • 13 Rob October 10, 2014, 7:11 pm
  • 14 qpop October 10, 2014, 9:08 pm

    @Lorenzo

    Vanguard offer their UK Equity Income Index tracker, which uses a dividend weighting as well as market cap weighting.

    IIRC they developed the index in conjunction with FTSE.

    https://www.vanguard.co.uk/adviser/adv/investments/mutualfunds/detailoverview?portId=9205&assetCode=EQUITY

Leave a Comment