Dilbert manages to put it brilliantly. You can find Scott Adams’ four cartoons “Boss gives Asok investment advice Serieshere. My favorite is the third one; benchmarks are indeed tricky.

In the long-running debate of whether active managers add value, what we could not fathom in the early days is how it would change once the passive alternative became widely available.

Benchmarks were developed for measurement purposes, as yardsticks for what the markets offered in terms of simple raw earning power. To be effective, a benchmark has to be well defined (in respect to the target market or sector), knowable (in how it is constructed), measurable and, more importantly, replicable (in case you want to be “neutral” or have no particularly strong ideas).

As an aside, many times investors attempt to indicate benchmarks that lack one or more of these attributes. A classic example is asking a manager to beat the average of all managers in a particular style or asset class. This is a dubious idea and not a proper benchmark: it is ill defined (managers change frequently), unknowable (what is the composition of such benchmark? what are other managers doing?), and as a consequence it is not replicable (how can you be neutral in such a situation?), even though it is measurable.

Until the widespread advent of passive investment vehicles, the attribute “replicable” was theoretically achievable, but only for the largest of institutional investors. Think about it: very few of us can own the entire S&P 500 Index in all its components, and certainly not at zero cost (which is how the index returns are calculated). The nature of the debate for most investors was simple: funds are the only way to get at least diversification and possibly good performance as well.

Today we have alternatives to actively managed mutual funds and at a cost that is often minimal (the S&P 500 can be replicated for as little as 0.09% p.a., excluding the commissions paid to acquire the vehicle). Investors have logically caught on and have filled their portfolios with passive vehicles. The nature of the debate has changed radically.

The industry has taken many actions to counteract this trend; one of the most creative is the rebranding of “smart beta” strategies. I say “rebranding” because once you understand what these strategies are you realize they’ve been around forever. Traditional benchmarks are composed of single securities that are weighted by market capitalization; smart beta strategies use other weighing parameters (earnings, sales, dividend yield, or any number of factors). Without getting into the merits of traditional benchmark construction, it is easy to recognize that smart beta funds replicate systematically investment strategies or processes that managers have been using for decades. In other words, they are active strategies and as such will behave differently than the relevant benchmark.

Nothing new under the sun, as I said; or to use a cynical Italian expression “il lupo cambia il pelo ma non il vizio.

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