Many equity investors are giving up on active management. In the US, a popular approach is to settle for a passive strategy based on the well-known S&P 500 Index. However, we think factor investing provides a much more compelling alternative.
In recent years, going passive seems to have become the default option for many equity investors, in particular in the US. As the largest and most liquid equity market in the world, the US stock market is also often perceived as the most efficient one, making it very difficult for active investors to consistently outperform the market.
In this context, passive investment strategies that replicate the popular S&P 500 Index have thrived, commercially speaking. Currently, a total of over USD 3.4 trillion is invested in passive vehicles that track this well-known index, according to the latest Annual Survey of Assets by S&P Dow Jones Indices. Vehicles that track the S&P 500 are widely available at low costs, sometimes as low as just a few basis points.
The appeal of passively tracking the S&P 500 is clear: the index offers exposure to liquid large-cap stocks from different sectors that represent over 80% of the total market capitalization of US equities. Moreover, investors don’t need to engage in extensive and expensive manager due diligence. Given its transparency, the passive portfolio does not hold any surprises in terms of sector or individual stock weights.
Investors should not settle for the S&P 500 Index
With such characteristics, it is not surprising that active managers face a strong opponent when competing for assets. And given the steep fees active managers sometimes charge, they actually start at a disadvantage. At Robeco, however, we argue that investors should not settle for the S&P 500 Index and that factor-based investing can provide a much better alternative.
To beat the S&P 500 Index after costs, consistently over time, a strategy should feature four key characteristics. First, it should include exposure to low relative risk, capturing a manager’s skill in the most efficient way by only allowing small deviations from the reference index. Second, it should have low costs, as costs can soon cancel out potential relative gains from such small deviations. Third, the strategy should provide efficient exposure to academically proven factors of return, such as value, momentum and quality. Finally, there should a disciplined quantitative implementation process, as the portfolio manager will have to continuously assess the potential of hundreds of stocks.
Robeco’s Enhanced Indexing strategies feature these characteristics, while also integrating sustainability criteria. Since 2004, these strategies have proven their ability to deliver stable and sustainable alpha after costs when applied to broad investment universes such as global developed and emerging stocks. But carve-outs of their realized performance show that our Enhanced Indexing strategies also work in narrower investment universes. This holds true even in the very efficient US stock market, making enhanced indexing a compelling alternative to passive S&P 500 strategies.
Read the related article: ‘How can you beat the S&P 500?’