The traditional choices: active vs. passive
For the past 35 years, investors have had two choices. If they believed markets were largely efficient, they chose to invest through capitalization-weighted index funds. If they believed markets were inefficient, they picked active management.
But both approaches are inherently flawed
Both approaches have their problems. Cap-weighted equity index funds tend to overweight overvalued securities and underweight undervalued ones, creating a 2% return drag in developed markets and more in less efficient ones. Active management is not transparent, comes with high fees, and tends to underperform the benchmark over long time periods.
Cap weighting doesn’t work for bonds either
For bonds, cap weighting is more obviously flawed, giving the biggest weights to the biggest debtors; this situation is particularly acute for sovereign bonds, where some developed market nations have sought to drive down yields, creating inefficiencies in the market and failing to reward investors for the risks they are taking.
Smart beta strategies offer a third choice
Smart beta strategies, such as non-price-weighted indices, offer a third choice. These strategy indices retain the benefits of traditional capitalization-weighted indices, such as broad market exposure, diversification, liquidity, transparency, and low cost access to markets. At the same time, they offer the opportunity to achieve superior performance over the cap-weighted benchmark.