Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 448

Smart beta funds complement active without key person risk

Some of the best movies have an ensemble, where each actor brings their unique skills to make the story work. Likewise, with a sports team, a single player cannot always lift a whole team to glory. In both of these instances, an idea to achieve the outcome gestates until either success, mediocrity or failure occur.

The same is true in funds management

Last month, the LA Rams won the 2022 Super Bowl. Coach Sean McVeigh built a team with a deep bench of superstars. Wide receiver Odell Beckham Jr went down with an injury in the second quarter but he was one of many skilful catchers in the Rams line-up. Any one of a dozen players could have been MVP in the big game. By building a team with a deep bench, McVeigh reduced his key person risk.

Other teams in the NFL rely on a franchise player, usually the quarterback. This person becomes the face of the franchise. The risk, of course, is if that one player is injured or has a run of bad form the team suffers more.

In sports, talent costs money. The same is true in funds management, hence the willingness of investors to pay premiums of active management. With active management, investors pay for the expertise of the star fund manager and/or the deep bench of analysts. The industry is rife with fund managers and investment gurus that live and breathe markets. Some genuinely have talent identifying opportunities while for others the self-belief is misplaced and they were just lucky, in the right place at the right time.

The difficulty for investors is determining if their active fund is managed by a deep bench of stars that are skilful, not lucky. This is easier said than done, as many fund managers are not transparent. It is difficult to get a complete list of holdings to determine how they are outperforming.

Global research house Morningstar in its biennial Global Investor Experience Report repeatedly ranks Australia last out of 26 global markets in terms of investment disclosure.

Ideally, investors should be able to assess performance over a long period. They should be able to look at the holdings and determine whether a fund outperformed because its managers were skilled at choosing the best securities, or were they just more heavily weighted into growth assets or those asset classes that have done best over recent periods?

Performance should come from multiple sources, across sectors, not just a single idea. In addition, outcomes should be persistent and consistent with stated expectations and marketing.

If a fund manager says their skill is identifying ‘value’, investors should expect when value shines, as it is now, so should they. Likewise, when a manager says they specialise in identifying ‘quality’ companies, expect they would fall less and recover faster during a downturn, as that is a key characteristic of quality.

It would be naïve to think any manager can outperform every month. Fund managers are human after all, so they will make mistakes. In investing, mistakes include selling too soon, holding a stock for too long and overlooking opportunities. Making mistakes can make some fund managers better investors but mistakes can lead to underperformance. As humans, they may become impatient and try to chase returns, or hold that stock they’ve fallen in love with, a stock which is cheap for a reason. Investors are human too, so persistent underperformance may lead to a run for the exit.

What is an investor to do?

There is of course a way to eliminate key person risk: passive management. It aims to replicate the returns of an index as opposed to active management that aims to outperform an index.

The days of outperforming the market are not gone. Investors that still want to achieve an outcome different from the market benchmark index and to take the ‘human element’ out of their portfolios could turn to smart beta ETFs.

Smart beta is at the intersection of active and passive management. It can explain a considerable portion of an active manager’s risk and return characteristics but it is not subservient to the human condition and our vulnerabilities. It does not ‘fall-in-love’ with stocks, is not impacted by what else is going on in its life and it does not retire or resign to work for a competitor. But there is a human behind the research and design of smart beta indices, and over the last 50 years, it has become more sophisticated. Smart beta ETF strategies are fully transparent so investors can see the holdings on a daily basis. 

Forewarning the rise of smart beta was a 2016 scholarly article published in the CFA Institute's Financial Analysts Journal. In their paper, ‘The Asset Manager's Dilemma: How Smart Beta is Disrupting the Investment Management Industry', authors Ronald Kahn and Michael Lemmon described smart beta as:

a disruptive financial innovation with the potential to significantly affect the business of traditional active management.” 

Their paper illustrated that current fee levels in the global equity universe were inconsistent with the performance outcome because the fees are too high. Over 35% of global equity managers, according to Kahn and Lemmon’s analysis, will be disrupted by smart beta.

The disruption is happening in Australia

Each year VanEck conducts a smart beta survey. Last year, the Sixth Annual Smart Beta Survey was the biggest survey of its kind worldwide.

A question directed at financial advisers demonstrated that the most important factor for an adviser selecting smart beta is not fees but performance.

Source: VanEck Smart Beta Survey, 2021

Active managers should take note. Each half year when S&P releases its SPIVA report for Australian funds it does not make good reading for active fund managers. During the most recent (half year 2021), the summary states:

“For longer measured periods (3, 5, 10, and 15 years), the majority of active funds underperformed their respective benchmark indices across categories.”

More worrying for active managers, the VanEck Smart Beta Survey indicates over 50% of advisers are using smart beta to replace active managers. The main reason is increased performance.

Source: VanEck Smart Beta Survey, 2021

The survey also found 99% of smart beta users are satisfied with their strategy. This finding has been consistent in every year of the survey. 

No fund manager, and for that matter, no index strategy will offer absolute returns all of the time. Investing involves risks. Key person risk is one such risk. Prudent investing means not just diversifying your bench across asset classes but also across investment styles.

The key for investors is to diversify and seek those strategies that endure through the cycle and the complex gauntlet that capital markets exhibit time and time again. It is common now to see smart beta as the core of a portfolio supported by high conviction active funds, or to see a core active manager blended with a complimentary smart beta strategy.

For more information on smart beta, click here.

 

Arian Neiron is CEO and Managing Director - Asia Pacific at VanEck, a sponsor of Firstlinks. This is general information only and does not take into account any person’s financial objectives, situation or needs.

For more articles and papers from VanEck, click here. VanEck's smart beta funds include an equal-weighted Australian equity fund (ASX:MVW) and global quality (ASX:QUAL).

 

RELATED ARTICLES

Is the passive investing dream waning?

Are markets broken?

The challenges of building a lazy portfolio

banner

Most viewed in recent weeks

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Welcome to Firstlinks Edition 606 with weekend update

The boss of Australia’s fourth largest super fund by assets, UniSuper’s John Pearce, says Trump has declared an economic war and he’ll be reducing his US stock exposure over time. Should you follow suit?

  • 10 April 2025

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

Investment strategies

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Investment strategies

Does dividend investing make sense?

Dividend investing offers steady income and behavioral benefits, but its effectiveness depends on goals, market conditions, and fundamentals - especially in retirement, where it may limit full use of savings.

Economics

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Strategy

Ageing in spurts

Fascinating initial studies suggest that while we age continuously in years, our bodies age, not at a uniform rate, but in spurts at around ages 44 and 60.

Interviews

Platinum's new international funds boss shifts gears

Portfolio Manager Ted Alexander outlines the changes that he's made to Platinum's International Fund portfolio since taking charge in March, while staying true to its contrarian, value-focused roots.

Investment strategies

Four ways to capitalise on a forgotten investing megatrend

The Trump administration has not killed the multi-decade investment opportunity in decarbonisation. These four industries in particular face a step-change in demand and could reward long-term investors.

Strategy

How the election polls got it so wrong

The recent federal election outcome has puzzled many, with Labor's significant win despite a modest primary vote share. Preference flows played a crucial role, highlighting the complexity of forecasting electoral results.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.