It’s no secret that the past few years have witnessed a pivot away from traditional active equity management and into index funds and other passive vehicles. With equities delivering strong returns since the post-crisis bottom in 2009, simple exposure to equity beta, or the market’s return, has been enough for many investors to achieve their return targets. But we believe that will change in the coming years, with equity returns likely to be significantly lower compared to recent levels (see Figure 1).

A lower-return environment suggests the need for alpha, but this creates a challenge for investors, as excess returns have been difficult to find. Numerous studies have pointed to the failure of traditional active managers to deliver market-beating returns. A recent study by Morningstar revealed that only 14% of U.S. large cap managers outperformed their passive counterparts over 10 years, and only about 30% of managers outperformed in the perceived less efficient areas of small cap, international and emerging markets. 

Some investors are undeterred by these statistics, continuing to allocate to active managers even while acknowledging that most will underperform due to the rise of closet indexing and the high fees stock pickers typically charge. For these investors, the path forward is through manager selection, with a view that high-conviction, high-active-share managers offer the greatest chance to outperform. While research does support this idea, “high conviction” often equates to “high tracking error,” and sometimes human behavior can get in the way of realizing attractive long-term returns. Indeed, performance chasing – by way of redeeming recently underperforming managers and hiring recent top performers – has cost investors about 200 basis points (bps) of annualized returns (see Figure 2).

Low returns, scarcity of alpha and the tendency to chase performance: With all of these challenges, how does an equity investor achieve higher returns going forward?

We believe part of the answer lies in portfolio structuring: that is, reallocating away from traditional passive and active strategies and toward structural or systematic approaches that may offer more reliable sources of returns. To be sure, investing in nontraditional equity strategies requires education and the ability to navigate an evolving landscape. But the potential rewards – achieving higher returns in an environment where beta alone may no longer be enough – could be meaningful.

Expanding the equity toolkit

Investors have traditionally employed a “core-satellite” framework in building their equity allocation, with the core consisting of market-cap-weighted indexes and the satellites represented by a handful of stock pickers. In a high-return environment, this structure was often sufficient to meet investors’ targets even if the active managers underperformed. Looking ahead, however, we think investors should consider strategies that can both diversify their equity exposure and offer the potential for higher and more consistent returns. The good news is there are a growing number of investment options that can complement or even replace traditional passive and active strategies. Specifically, passive allocations may now include smart beta solutions, while systematic active and portable alpha strategies offer compelling options for the active portion of an equity portfolio.

Smart beta: More than a buzzword

While the first smart beta strategies were developed more than a decade ago, the hype around smart beta has been a more recent phenomenon. Many investors have struggled to understand exactly what smart beta is, and their confusion has been compounded by the fact that many managers with a quantitative process or factor orientation have (perhaps erroneously) attached that label to their strategies. But the definition of smart beta, as we see it, has evolved into something quite specific: A passive, transparent, replicable index that weights stocks based on some metric other than price. 

By removing price from the weighting methodology and periodically rebalancing back to those weights, smart beta strategies can contra-trade the cap-weighted market to exploit inefficiencies and capture returns. As part of a passive allocation, smart beta strategies should be economically representative, low cost and have large capacity and liquidity. With these characteristics, smart beta can retain many of the benefits of traditional passive but offer the potential for higher returns.

Systematic active: A more disciplined approach to active equity

Systematic active equity strategies follow a rules-based investment process that may offer more reliable excess returns than traditional stock picking. Systematic active equity strategies often have the same investment objectives as traditional active equity managers: They seek to buy low and sell high and consider the quality and growth prospects of individual companies, while being strategic about the timing of trades and position sizes, i.e., how best to allocate active weights. And as with traditional stock pickers, they also seek to improve their processes based on ongoing research and lessons learned. The key difference? Systematic equity strategies can benefit from the discipline of an unemotional, rules-based decision-making process.

The result is that systematic active equity strategies may offer a more consistent approach, and one that can be truly contrarian. In addition, given that these strategies are driven by quantitative models rather than teams of research analysts, systematic equity typically comes with lower fees. For investors seeking excess returns in a low-return environment, we believe these systematic active approaches offer an attractive alternative or complement to traditional stock-picking strategies.

Portable alpha: Benefiting from structural sources of returns

For investors interested in nontraditional equity strategies, we believe portable alpha approaches possibly deliver the most consistent outperformance in the equity space and are well worth exploring. While not traditional, portable alpha – or “index plus” – strategies are nevertheless relatively simple: They gain passive exposure to equities through instruments such as futures, and then invest in an alpha strategy that seeks to outperform the cost of obtaining that exposure.

The design of the alpha strategy is critical to the success of this approach. We believe it should target high quality assets and aim to be highly liquid, flexible and largely uncorrelated to equities, thereby allowing for excess returns with a risk profile very similar to the equity benchmark.

The distinguishing feature of a successful index-plus strategy is consistent outperformance compared to traditional active approaches, particularly when viewed over rolling three- and five-year periods. In our experience, taking advantage of structural return opportunities in the bond market to outperform that money-market cost of equity exposure has been the key to success. Put simply, if an active bond manager can outperform cash, then an index-plus approach should deliver alpha on top of the desired equity benchmark returns.

Key takeaways

Investors are facing a dilemma when contemplating their equity allocations: With returns expected to be lower going forward, they need reliable alpha, but active managers as a group have not delivered. Fortunately, both passive and active equity strategies have evolved to offer investors more choices. Rethinking traditional approaches and moving toward strategies that benefit from systematic and structural sources of returns may help investors to achieve the excess returns they seek.