Active versus Passive Management
September 13th, 2015 - LAPERS
Darren Fournerat, CFA, CAIA
Laney Sanders, CFA
Agenda
• Defining “Active” and “Passive” for
portfolio management
• Different approaches for implementation
for each tactic
• Support for each strategy
• Current market dynamics
• Smart Beta
2
Portfolio Management Process
• Strategic or tactical asset allocation
decisions
– Allocation to a particular asset class
• Implementation
– What is the best way to invest in that asset
class?
– Use Active or Passive approach?
3
Active versus Passive
• Active management seeks to outperform a given
benchmark
– Overweight or underweight securities relative to
appropriate benchmark in an attempt to “beat the
market”
• Passive management simply seeks to gain
exposure to a certain market
– Does not express investment expectations as to which
securities will outperform within that particular
market
4
Spectrum of Portfolio Management
Active
Passive
Index Fund
Enhanced
Indexing /
Semi active
Long Only
Benchmark
constrained
Long / Short
Hedge Funds
5
Passive Management - Indexing
•
An index fund is a portfolio of securities that is purchased, held and
managed in order to match the return and risk characteristics of an index
– Two types of index funds include:
• Fully Replicated
– An index fund that holds every single security in the index,
and each position will have approximately the same weight in
the fund as in the index
• Optimized
– An index fund that holds a “representative” sample of
securities that is determined by advanced mathematical
programming software
6
Passive Management – Indexing
• Indexing is the most prevalent approach to passive
investing
• Attempt to match the performance of a pre-specified
benchmark
• Began in the 1970s
– Quickly grown to where it is today – U.S. alone has more than $1
trillion in institutional indexed equities
• Despite this growth, active management still accounts
for the overwhelming majority of equity assets managed
7
Active Management
• Seeking to outperform the market
• Types of Active management
– Almost Passive
• Enhanced indexing
• Smart Beta
– Constrained
• Long-only
– Unconstrained
• Long-Short hedge fund
8
Active Management
• Considerations for hiring active managers
– Which benchmark is appropriate?
– What constraints will be placed on the manager to
manage risk?
• Exposure limits
• Pre-defined sub-asset class ranges
• Are they allowed to short and / or use leverage?
– What fees do they charge?
• Flat management fee?
• Performance based fee?
9
Support of Passive Management
• After fees, the return of the average actively
managed dollar, will be less than the average
passively managed dollar*
• Limited evidence that performance persistence
exists
– Makes consistently selecting top active managers very
difficult
• Time and resources needed for active
management
*Source - The Arithmetic of Active Management” by William Sharpe
10
Support of Active Management
• Market “anomalies” do exist
– Size Effect
– Value Effect
• Modern Portfolio theory / Efficient market
hypothesis does not consider “behavioral
biases”
– Traditional theory assumes all investors act
rationally
11
Market Efficiency
• An efficient market is one in which asset
prices reflect new information rationally
and quickly
– Less efficient markets usually present greater
opportunities for excess return, or “alpha”
• Market capitalization
• Developed versus emerging
• Traditional versus alternative
12
Opportunities for Outperformance
13
Current Market Dynamics
• Strong U.S. equity performance recently
has made it difficult for active managers
– S&P 500 gained nearly 75% for the three-year
period ending December 31st, 2014
– Index finished in the top quartile of Large Cap
domestic active managers
14
Current Market Dynamics
• Why have active managers struggled?
– Active managers target higher quality stocks,
in general
• In the “risk-on” environment created by
quantitative easing in the U.S., lower-quality
stocks managed to outpace better-quality stocks
for three years
– Active managers keep some cash, or “dry
powder,” to be able to quickly execute
opportunities as they present themselves
• Cash drag is magnified when returns are high
15
Smart Beta – Growth and Popularity
16
Smart Beta
• Smart beta strategies attempt to deliver a better
risk and return trade-off than conventional
market cap weighted indices by using
alternative weighting schemes
• Take advantage of perceived systematic biases or
inefficiencies in the market
– i.e.: size, value, volatility
• Claims to offer market-beating returns with a
rules based, simplistic, and low cost approach
17
Smart Beta – Growth and Popularity
• Key findings of Invesco’s Evolution of
Smart Beta ETFs
– 1 in 3 (36%) institutional decision makers indicate they are
currently using Smart Beta ETFs
– 64% of institutions indicate they are likely to increase their use of
ETFs over the next three years
– Six in ten institutional investors surveyed are now familiar with
smart beta ETFs, up from 54% last year
– Nearly two-thirds of institutional decision makers expect to
increase their use of smart beta ETFs over the next three years
18
Smart Beta – What is holding it back?
19
How “Smart” is Smart Beta?
• Smart Beta portfolios are not really passive
– Actively betting on certain “factors” to outperform
– Decision to not hold cap-weighted index
– Must decide weighting and rebalancing rules
• Vulnerable to being replicated, overcrowded, and are
prime targets for front-running
– Most of the common factors are already known by the markets
– More transparent than active strategies
• Given the same universe, smart beta strategies are not
diversifying to traditional cap-weighted indices
20
Wrapping up: Active or Passive
• Things to consider:
– Market efficiency
• Less efficient markets can present an opportunity
for active management to outperform
– Risk tolerance
• Active management will expose you to some level
of tracking error (active risk)
– Fee tolerance
• The more active the strategy, the higher the fees
– Staff resources
• Hiring and overseeing active managers takes time
21