A New Playbook for Combining Active, Passive and Smart Beta

A New Playbook for Combining Active, Passive and Smart BetaMutual fund guru Peter Lynch coined the term “diworsification” to describe companies that expand beyond their core competencies and thereby destroy value. This concept can also be applied to investors who “over-diversify” into overlapping strategies, according to Chris Arthur, Senior Global Relationship Manager for Eaton Vance. In a new white paper, Mr. Arthur offers “a new playbook for diversification” that moves beyond simple asset allocation and style-box investing.

According to Mr. Arthur, to “properly” diversify a client’s portfolio entails continuous monitoring and the adjustment of allocations, which can be daunting. This goes well beyond deciding between active and passive investing styles, which Mr. Arthur considers a problematic way of viewing things. Instead, he says advisors should determine their clients’ values and then provide them with a mix of active, passive, and smart beta exposures to meet their objectives.

Active/ Passive / Smart Beta

Active management allows managers to select specific investments rather than buying the whole market, and this obviously affords savvy stock pickers more opportunities for alpha generation. On the downside, winning active strategies are difficult to identify ex-ante, and they are particularly sensitive to market cycles.

Passive management provides inexpensive exposure to the broad market, and passive exposure may help advisors temper their clients’ expectations. Since passively indexed strategies are price-weighted, though, they are susceptible to concentration risk; and while their fees are low, they’re not zero, so passive strategies inherently underperform the benchmarks they’re designed to track.

Smart beta strategies are a hybrid between active and passive management, offering a rules-based investment approach (like passive) but with performance that varies greatly from standard benchmarks (like active). Smart beta strategies are more transparent than active management, but the category isn’t well-defined and thus not well-understood. This shouldn’t prevent advisors and their clients from incorporating smart beta strategies into their portfolios, but there is an educational hurdle that needs to be overcome.

Values Discovery

Values discovery is the process of determining each client’s realistic objectives. These objectives should account for various factors, including the client’s wealth, income, time horizon, age, obligations, investment knowledge, and personal financial history, according to Mr. Arthur. In his words, “the framework to build the proper investment strategy for clients needs to be adjusted.”

Once determining a client’s investment objectives, Mr. Arthur recommends constructing appropriate portfolios by combining exposure to active, passive, and smart beta strategies. Whereas the “old diversification” model may have relied on stocks, bonds, cash, and “alternatives;” Arthur thinks the new playbook should offer strategic and tactical options involving active, passive, and smart beta allocations.

Old Diversification

Market Dynamics

Beyond client values, what factors should advisors take into account when constructing portfolios? Mr. Arthur lists several:

  • The level of interest rates;
  • Market direction;
  • Volatility levels (as measured by the VIX);
  • A breakdown of returns between market, sector-industry, and company;
  • The correlation among securities over 63-, 126-, and 252-day periods;
  • The cross-sectional volatility of the market.

Interest rates are still near record lows, but the Federal Reserve removed the word “patient” from its interest rate guidance at its last meeting on March 18. Rising interest rate levels have typically been more bullish for active managers.

In terms of the VIX, Mr. Arthur has indicated two key levels, 16 and 21, for forecasting. When the three-year average of the VIX has been below 16 or above 21, active managers have generally outperformed.

When the VIX three-year average is above 21 or below 16

Furthermore, Mr. Arthur’s analysis indicates that when one-day correlations over 63-, 126-, and 252-day periods is greater than 0.55, active management in the growth category has tended to outperform. This is helpful knowledge for advisors with clients that have growth as an objective – active growth has also historically performed well with the VIX below 16 and above 21, as well.


“Past performance may not be indicative of future results,” as Mr. Arthur admits. But given the current market dynamics and the telegraphing of future Fed policy, it would seem as though active managers will have greater ease in separating themselves from their benchmarks in 2015. Mr. Arthur wraps up the paper by providing a summary table of potential allocations to active, passive and/or smart beta for each signal.

For more information, download a pdf copy of the whitepaper.

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