The Active vs. Passive Investment Debate

On the One hand…..

….. And on the Other Hand

Definitions

Passive (Index) Management

Two Meanings

Security Selection:

Match performance of an asset class index such as the S&P/TSX Composite Index

Asset Mix:

Match performance of a policy mix (such as 50% stocks/50% bonds)

2

Definitions

Active Management

Two Strategies

Market Timing:Timing asset class exposure to earn a

return that exceeds the return available by maintaining a constant asset mix (for e.g. 50% stocks/50% bonds)

Security Selection:Selecting securities to earn a return that

exceeds the return available from investing in an index such as the S&P Index

3

Active vs. Passive Investment

Management

4

Security Selection

Issues to Consider:

Philosophical

Is the Market Efficient?

Practical

Can Active Managers

“Beat the Market?”

A. Philosophical: Is the

Market Efficient?5

What Does This Mean?

1. Investors Earn Returns Commensurate with

Risk, ie., No Free Lunch

2. Various Forms of Theory:

Weak

Semi-Strong

Strong

Efficient Market =

Securities Reflect All Available

Information

A. Philosophical: Is the

Market Efficient?6

Weak Form

A security’s price reflects all the information contained in the

historic price record. Past prices cannot provide information

of any value in helping to determine future prices.

Semi Strong Form

At any given time, all relevant public information is fully

reflected in the security’s price.

Strong Form

All public and private information is fully reflected in the

security’s price

B. Can Active Managers

“Beat the Market”

7

Active Passive

The Secret Formula of Active Investment

Management

Information Ratio = Manager’s Skill × √ Breath

8

The Fundamental Law of Active Management

Number of Independent

Forecasts of E ( R )

Source: Active Portfolio Management, by R. Grinold & R. Kahn, McGraw Hill, New York, NY, 2000

Relationship Between

Forecasts and Actual

Outcomes

Information Ratio = (Excess Return)/(Tracking Error)

Tracking Error = Standard Deviation of Excess Return

Long Term Observations…..9

Average Manager Return = Market Return

The Market Rewards Different Factors over Time

Successful Active Managers Need Both Skill and Breadth

Active Management Pay Off For Managers in The Top Third of the Universe

Active vs. Passive Management

“Properly measured, the average actively managed dollar must

under-perform the average passively managed dollar net of costs.

Active management is indeed a zero-sum game”

– Bill Sharpe, Noble Prize Winner in Economics

So Why Can Active Management

Sometimes Be Frustrating From a Client

Perspective?

Over Emphasis on Short Term Past Performance

Under Emphasis of Manager “Style” and Process

Organizational Uncertainty Challenges

Success Can Lead to Mediocrity

10

Success Can Lead to

Mediocrity

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Why?

“Bets” Diminish Over Time Due To:

1. Increase in Transaction Costs

2. Increase in “Qualified” Employees

3. Business Decision

• No Skill

• Protective Mode

Alpha Shrinkage As Assets

Multiply

12

Source: Asset Growth and Its Impact on Expected Alpha, by R.Kahn, in Global Perspectives on Investment Management, CFA

Institute, 2006, pages 197 – 212

Value

Added

0Assets Under Management

Beat the

Market

Lose to

the

Market

Imagine a business in which other people hand you their money to look after and pay you handsomely for doing so. Even better, your fees go up every year, even if you are hopeless at the job. It sounds perfect.

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“

”

The EconomistMarch 1, 2008, Special Report on Asset Management

Active vs. Passive Equity Portfolio Management

The “conventional wisdom” held by many investment analysts is that there is no benefit to active portfolio management because:

- The average active manager does not produce returns that exceed those of the benchmark

- Active managers have trouble outperforming their peers on a consistent basis

However, others feel that this is the wrong way to look at the Active vs. Passive management debate. Instead, investors should focus on ways to:

- Identifying those active managers who are most likely to produce superior risk-adjusted return performance over time

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The Wrong Question

Stylized Fact:

Most active mutual fund managers cannot outperform the

S&P 500 index on a consistent basisBeat %

10%

30%

50%

70%

90%

DATE

JAN80 JAN82 JAN84 JAN86 JAN88 JAN90 JAN92 JAN94 JAN96 JAN98 JAN00 JAN02 JAN04

6 - 15

The Wrong Question (cont.)

6 - 16

0102030405060708090

100

0 10 20 30 40 50 60 70 80 90100

S&P 500

Diversified Equity

Mutual Funds

Stylized Fact:

Most active mutual fund managers compete against the

“wrong” benchmark

Defining Superior Investment

Performance

Over time, the “value added” by a portfolio

manager can be measured by the difference

between the portfolio’s actual return and the

return that the portfolio was expected to produce.

This difference is usually referred to as the

portfolio’s alpha.

Alpha = (Actual Return) – (Expected Return)

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Measuring Expected Portfolio Performance

In practice, there are three ways commonly used to measure the return that was expected from a portfolio investment:

- Benchmark Portfolio Return

Example: S&P 500 or Russell 1000 indexes for a U.S. Large-Cap Blend fund manager

Pros: Easy to identify; Easy to observe

Cons: Hypothetical return ignoring taxes, transaction costs, etc.; May not be representative of actual investment universe; No explicit risk adjustment

- Peer Group Comparison Return

Example: Median Return to all U.S. Small-Cap Growth funds for a U.S. Small-Cap Growth fund manager.

6 - 18

Pros: Measures performance relative to manager’s actual competition

Cons: Difficult to identify precise peer group; “Median manager” may ignore large dispersion in peer group universe; Universe size disparities across time and fund categories

- Return-Generating Model

Example: Single Risk-Factor Model (CAPM); Multiple Risk-Factor Model (Fama-French Three-Factor, Carhart Four-Factor)

Pros: Calculates expected fund returns based on an explicit estimate of fund risk; Avoids arbitrary investment style classifications

Cons: No direct investment typically; Subject to model mis-specification and factor measurement problems; Model estimation error

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The Right AnswerWhen judging the quality of active fund

managers, the important question is not whether:

The average fund manager beats the benchmark

The median manager in a given peer group produces a positive alpha

The proper question to ask is whether you can select in advance those managers who can consistently add value on a risk-adjusted basis

Does superior investment performance persist from one period to the next and, if so, how can we identify superior managers?

6 - 20

Lessons from Prior Research

Fund performance appears to persist over time

Original View:

Managers with superior performance in one periodare equally likely to produce superior or inferiorperformance in the next period

Current View:

Some evidence does support the notion thatinvestment performance persists from one period tothe next

The evidence is particularly strong that it is poorperformance that tends to persist!

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Security characteristics, return momentum, and fund styleappear to influence fund performance

Security Characteristics:

After controlling for risk, portfolios containing stockswith different market capitalizations, price-earningsratios, and price-book ratios produce different returns

Funds with lower portfolio turnover and expenseratios produce superior returns

Return Momentum:

Funds following return momentum strategiesgenerate short-term performance persistence

Momentum investing is a system ofbuying securities that have had high returns over thepast three to twelve months, and selling those thathave had poor returns over the same period.

Security characteristics, return momentum, and fund style appear to influence fund performance (cont.)

Fund Style Definitions:

After controlling for risk, funds with differentobjectives and style mandates produce differentreturns

Value funds generally outperform growth funds on arisk-adjusted basis

Style Investing:

Fund managers make decisions as if theyparticipate in style-oriented return performance“tournaments”

The consistency with which a fund managerexecutes the portfolio’s investment style mandateaffects fund performance, in both up and downmarkets 6 - 23

Security characteristics, return momentum, and fund style appear to influence fund performance

(cont.)

Active fund managers appear to possess genuine investmentskills

Stock-Picking Skills:

Some fund managers have security selection abilities that addvalue to investors, even after accounting for fund expenses

A sizeable minority of managers pick stocks well enough togenerate superior alphas that persist over time

Investment Discipline:

Fund managers who control tracking error generate superiorperformance relative to traditional active managers andpassive portfolios

Manager Characteristics:

The educational backgrounds of managers systematicallyinfluence the risk-adjusted returns of the funds they manage

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Active vs. Passive Management: Conclusions

Both passive and active management can play a

role in an investor’s portfolio

Strong evidence for both positive and negative

performance persistence (i.e., alpha persistence)

Prior alpha is the most significant variable for forecasting future alpha

Expense ratio, risk measures, turnover and assets are also useful in

forecasting future alpha

The existence of performance persistence provides

a reasonable opportunity to construct portfolios

that add value on a risk-adjusted basis