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”
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Active Passive
The Secret Formula of Active Investment
Management
Information Ratio = Manager’s Skill × √ Breath
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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.
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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