Download The Active vs. Passive Management Debate

The Active vs. Passive Investment Debate
Discussion on:
The Rewards and Risks of Active vs. Passive Investment Management
On the One hand…..
….. And on the Other Hand
Harry Marmer, CFA, MBA – Executive Vice President, Hillsdale Investment Management
Agenda
• Are Markets Efficient?
• Can Managers Add Value?
• Where is Active Management Going?
2
Definitions
Passive (Index) Management
Two Meanings
3
•
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)
Definitions
Active Management
Two Strategies
4
•
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/TSX
Composite Index
Market Timing Track Record – Low Odds Strategy
Average Annual Value Added
North American Value Added Experience
Asset Mix Timing
5
Source: The Portable Pension Fiduciary: A Handbook for Better Pension Fund Management
(Toronto: Benefits Canada, 1997 page 62) , by John Ilkiw
Security Selection
Why Market Timing is Unprofitable?
“Historical Analysis Indicates You Must Be
Right At Least 2/3 of the Time*
A. Bull markets last longer than Bear markets
B. Stocks go up more over time than go down
C. Most upward performance occurs in
unpredictable spurts
6
*Source: Bill Sharpe, “Likely Gains from Market Timing” Financial Analyst Journal (March/April 1975, Pg 60-69)
Active vs. Passive Investment Management
Security Selection
Issues to Consider:
7
Philosophical
Practical
Is the Market Efficient?
Can Active Managers
“Beat the Market?”
A. Philosophical: Is the Market Efficient?
Eugene Fama (1965)
Efficient Market =
Securities Reflect All Available Information
What Does This Mean?
1. Investors Earn Returns Commensurate with
Risk, ie., No Free Lunch
2. Various Forms of Theory:

Weak

Semi-Strong

Strong
8
A. Philosophical: Is the Market Efficient?
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
9
A. Philosophical: Is the Market Efficient?
So…What Do Academics Think?
1960 – 1970’s
Markets Are Efficient Except to Some Degree
in the Strong Form
10
Proliferation of Databases and Software
11
A. Philosophical: Is the Market Efficient
1980’s
Computers & Databases
led us to:
 Small Firm Effect
 Weekend and Monday Effect
 January Effect
 Low P/E Effect
 Low P/Book Effect
12
A. Philosophical: Is the Market Efficient?
1990’s : 3 Views
1. Markets ARE Efficient
– Data Mining
– Fees
– Risk
2. Markets are NOT Efficient
– Technical Trading Patterns
– Chaos
– Professional vs. Noise Traders
(ie, Banks, Individuals, the Herd)
– A.I., Neural Net
– Fads, Bubbles, etc
– TAA – Forecast Returns (Fama)
13
3. Bounded Market Efficiency
.
.
.
.
The Market is Efficient?
Postwar Movements in S&P Index and Their Causes*
Date
Percentage Change
1
19-Oct-87
-20.47%
2
21-Oct-87
9.10%
Interest rates continue to fall; deficit talks in Washington; bargain hunting
3
29-Sep-08
-8.80%
Congress Votes against Wall Street bailout package
4
26-Oct-87
-8.28%
Fear of budget deficits; margin calls; reaction to falling stocks
5
3-Sep-46
-6.73%
"…. No basic reason for the assault on prices"
6
28-May-62
-6.68%
Kenndy forces rollback of steel price hike
7
26-Sep-55
-6.62%
Eisenhower suffers heart attack
8
26-Jun-50
-5.38%
Outbreak of Korean War
9
20-Oct-87
5.33%
Investors looking for "quality stocks"
10
9-Sep-46
-5.24%
Labor unrest in maritime and trucking
11
16-Oct-87
-5.16%
Fear of trade deficit; fear of higher interest rates; tension with Iran
12
27-May-70
5.02%
Rumours of change in economic policy. "….the stock surge happened for no fundamental reason"
13
11-Sep-86
-4.81%
Foreign governments refuse to lower interest rates; crackdown on triple watching announced
14
17-Aug-82
4.76%
Interest rate declines
15
29-May-62
4.65%
Optimistic brokerage letters; institutional and corporate buying; suggestions of tax cut
49
30-Nov-82
3.23%
"..analysts were at a loss to explain why the Dow jumped so dramatically in the last two hours.."
50
24-Oct-62
3.22%
Khrushchev promises no rash decisions on Cuban Missile Crisis; calls for US-Soviet summit
..
14
..
..
New York Times Explanation
Worry over dollar decline and trade deficit; Fear of US not supporting dollar
..
..
Less than 25% of Major Moves can be Attributed to a Specific World
Political or Economic Event**
*Source: Hillsdale Investment Management Inc.
*Source: NBER Working Paper No. 2538, “What Moves Stock Prices?”, by David Cutler, James Poterba, and Lawrence Summers, March 1988. In “Events
That Shook The Market”, Roy C. Fair found that “many large stock price changes have no events associated with them” , Page 713, Journal of Business 2002
**Source: Page 217, Chapter 13, World Events That Impact Financial Markets, “Stocks for the Long Run”, Jeremy J. Siegel,
B. Can Active Managers “Beat the Market”
Active
15
Passive
The Secret Formula of Active Investment Management
The Fundamental Law of Active Management
Information Ratio = Manager’s Skill × √ Breath
Relationship Between
Forecasts and Actual
Outcomes
Number of Independent
Forecasts of E ( R )
Information Ratio = (Excess Return)/(Tracking Error)
Tracking Error = Standard Deviation of Excess Return
16 Source: Active Portfolio Management, by R. Grinold & R. Kahn, McGraw Hill, New York, NY, 2000
In Other Words, Smart Managers Count Cards
17
Let’s Review If There are Smart Managers and if They Can
Count Cards
• Cdn Fixed Income
• Cdn Equity
• U.S. Large Cap
• U.S. Small Cap
• Global Equity
18
How Have Active Canadian Bond Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. Scotia Capital Universe
1.6
Excess Return (%)
1.2
0.8
0.4
0.0
-0.4
-0.8
-1.2
-1.6
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1st Quartile - SCU
0.2
1.3
0.5
1.0
1.5
0.0
1.1
0.3
0.7
0.8
0.1
0.8
0.4
0.4
0.5
0.3
0.7
0.6
0.3
0.3
0.3
0.1
Median - SCU
-0.7
0.5
0.0
0.0
0.7
-0.6
0.2
-0.3
0.2
0.0
-0.5
0.0
0.1
0.0
0.1
0.0
0.1
0.2
0.0
0.1
0.2
-0.2
3rd Quartile - SCU
-1.1
-1.0
-0.5
-0.2
0.2
-1.3
-0.2
-1.1
-0.7
-0.6
-1.0
-0.4
-0.1
-0.5
-0.1
-0.5
-0.4
-0.1
-0.4
-0.2
0.0
-0.7
19
Data Source: Mercer Investment Consulting Pooled Fund Survey
Tough to Sell Active Canadian Fixed Income
Annual Spread (%) Between Canadian Fixed Income Managers:
1st Quartile vs. Median and 3rd Quartile vs. Median
1st Quartile - Median:
Mean (1986-1997) = 0.72
1.5
1st Quartile - Median:
Mean (1998-2007) = 0.34
0.76
0.96
0.48
0.0
-0.42
-0.55
-0.24
0.75
-0.49
-0.5
0.63
-0.70
0.88
0.59
-0.40
-0.81
0.82
0.57
-0.81
-0.58
0.60
-0.50
0.72
0.32
-0.41
-0.26
0.38
-0.45
-1.51
-1.0
0.38
-0.20
0.31
-0.45
0.63
-0.55
0.39
0.29
-0.36
-0.39
0.26
-0.24
0.12
-0.17
2006
0.93
2005
0.5
0.30
-0.50
3rd Quartile - Median:
Mean (1998-2007) = -0.36
3rd Quartile - Median:
Mean (1986-1997) = -0.62
1st Quartile - Median
20
Data Source: Mercer Investment Consulting Pooled Fund Survey
3rd Quartile - Median
2007
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
-2.0
1987
-1.5
1986
Spread (%)
1.0
Why is the Canadian Bond Market so Tough to Beat?
• What Unique Information do Managers Have on Interest Rates?
• How Many Times Can They Apply These Forecasts?
• How Do You Beat The Bond Market?
– “Call” on Interest Rates
– Spreads
21
How Have Canadian Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. S&P/TSX Composite
25.0
1st Quartile - TSX
Mean (1990-1998) = 4.9
20.0
Excess Return (%)
15.0
1st Quartile - TSX
Mean (1999-2002) = 11.9
1st Quartile - TSX
Mean (2003-2007) = 2.7
10.0
5.0
0.0
-5.0
-10.0
3rd Quartile - TSX:
Mean (1990-1998) = -1.5
-15.0
3rd Quartile - TSX:
Mean (2003-2007) = -2.7
3rd Quartile - TSX:
Mean (1999-2002) = -1.9
-20.0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1st Quartile - T SX
7.1
4.7
5.9
-0.8
2.5
2.7
5.0
12.3
5.0
1.3
20.4
17.8
8.0
2.1
3.4
3.3
2.3
2.4
Median - T SX
5.5
2.0
3.3
-3.2
-0.3
0.6
0.0
5.6
1.5
-6.1
12.7
12.3
5.3
-0.9
1.2
-0.4
0.3
-1.8
3rd Quartile - T SX
4.0
-1.0
-0.5
-6.8
-1.6
-1.3
-3.4
-1.9
-1.3
-19.2
5.1
5.6
0.7
-3.9
-0.3
-3.4
-1.6
-4.1
Statistics
22
Source: eVestment Alliance
1st Quartile –
S&P/TSX Composite
Median –
S&P/TSX Composite
3rd Quartile –
S&P/TSX Composite
Mean
5.9
2.1
-1.9
Median
4.0
0.9
-1.5
Stdev
5.7
4.8
5.4
High
20.4
12.7
5.6
Low
-0.8
-6.1
-19.2
How Have Canadian Small Cap Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. S&P/TSX Small Cap Index
25.0
Excess Return (%)
20.0
15.0
10.0
5.0
0.0
-5.0
-10.0
-15.0
-20.0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
1st Quartile - TSX Small Cap
17.83
14.14
8.21
1.70
4.76
2.49
20.83
13.98
7.73
-3.85
16.24
19.57
18.30
14.04
22.16
17.12
11.05
14.58
M edian - TSX Small Cap
8.13
4.31
7.85
0.86
-0.54
-0.21
13.71
11.16
-1.24
-9.01
8.34
10.51
8.88
5.13
15.15
13.42
4.20
8.69
3rd Quartile - TSX Small Cap
2.81
-0.57
7.45
-0.63
-3.72
-5.18
6.03
2.67
-10.34
-13.39
1.83
3.76
6.17
-5.93
8.14
8.55
0.05
2.42
Statistics
23
Source: eVestment Alliance
1st Quartile –
S&P/TSX Small Cap
Median –
S&P/TSX Small Cap
3rd Quartile –
S&P/TSX Small Cap
Mean
12.3
6.1
0.6
Median
14.1
8.0
2.1
Stdev
7.3
6.3
6.3
High
22.2
15.2
8.5
Low
-3.8
-9.0
-13.4
How Have U.S. Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. S&P 500 Index
25.0
Excess Return (%)
20.0
1st Quartile – S&P 500
Mean (1998-2001) = 11.3
1st Quartile – S&P 500
Mean (1990-1997) = 4.4
15.0
1st Quartile – S&P 500
Mean (2002-2007) = 5.1
10.0
5.0
0.0
-5.0
-10.0
3rd Quartile – S&P 500:
Mean (1990-1997) = -2.8
-15.0
-20.0
1st Quartile - S&P 500
3rd Quartile – S&P 500:
Mean (2002-2007) = -2.5
3rd Quartile – S&P 500:
Mean (1998-2001) = -6.8
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
4.7
10.5
5.7
7.2
1.5
1.2
3.2
1.4
5.2
10.8
19.1
10.2
6.3
4.3
4.7
5.4
2.2
7.7
M edian - S&P 500
1.4
3.2
1.9
3.1
-0.9
-1.7
0.3
-1.7
-4.2
-0.2
9.7
3.3
1.5
0.5
1.4
2.7
-1.2
2.1
3rd Quartile - S&P 500
-2.1
-1.8
-0.8
-1.4
-2.7
-5.8
-2.5
-5.5
-12.5
-11.8
0.7
-3.6
-2.8
-2.7
-1.7
0.1
-5.9
-1.8
Statistics
24
Source: eVestment Alliance
1st Quartile –
S&P 500
Median –
S&P 500
3rd Quartile –
S&P 500
Mean
6.2
1.2
-3.6
Median
5.3
1.4
-2.6
Stdev
4.4
2.9
3.6
High
19.1
9.7
0.7
Low
1.2
-4.2
-12.5
How Have U.S. Small Cap Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. Russell 2000 Index
25.0
Excess Return (%)
1st Quartile – R2000
Mean (1999-2001) = 22.2
1st Quartile – R2000
Mean (1990-1998) = 11.1
20.0
1st Quartile – R2000
Mean (2002-2007) = 6.6
15.0
10.0
5.0
0.0
-5.0
3rd Quartile – R2000:
Mean (1999-2001) = -6.6
3rd Quartile – R2000:
Mean (1990-1998) = -2.0
-10.0
3rd Quartile – R2000:
Mean (2002-2007) = -4.3
-15.0
-20.0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
1st Quartile - Russell 2000
16.5
M edian - Russell 2000
9.5
3rd Quartile - Russell 2000
3.9
22.2
4.0
5.8
6.4
12.6
12.0
11.5
8.8
25.6
25.6
15.5
4.6
-0.6
1.4
3.2
3.4
7.3
4.6
1.3
-0.9
16.1
4.8
-4.6
-6.1
-4.2
-0.1
-2.9
1.6
-3.0
-3.0
-15.3
3.1
-7.6
Statistics
25
Source: eVestment Alliance
1st Quartile –
Russell 2000
Median –
Russell 2000
3rd Quartile –
Russell 2000
Mean
11.4
3.4
-3.5
Median
11.1
3.3
-3.6
Stdev
7.3
4.4
4.5
High
25.6
16.1
3.9
Low
0.8
-2.9
-15.3
2003
2004
2005
2006
2007
11.1
4.5
5.1
4.0
-1.6
1.0
6.7
0.8
11.2
3.3
-2.9
3.2
-5.0
-7.2
-4.4
0.5
-6.9
-2.5
How Have Global Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. MSCI World Index
25.0
1st Quartile – S&P 500
Mean (1990-1997) = 7.6
Excess Return (%)
20.0
1st Quartile – S&P 500
Mean (1998-2001) = 10.6
15.0
1st Quartile – S&P 500
Mean (2002 - 2007) = 5.1
10.0
5.0
0.0
-5.0
-10.0
3rd Quartile – S&P 500:
Mean (1990-1997) = -0.6
-15.0
-20.0
3rd Quartile – S&P 500:
Mean (2002 - 2007) = -1.9
3rd Quartile – S&P 500:
Mean (1998-2001) = -2.5
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
1st Quartile - M SCI World
11.38
7.38
10.96
15.61
-0.75
2.38
6.84
M edian - M SCI World
6.85
3.54
6.36
5.54
-5.26
0.08
4.7
3rd Quartile - M SCI World
4.78
-2.76
2.93
-0.09
-6.41
-3.62
3.3
-2.94
7.2
1.94
20.97
13.86
5.69
4.74
4.19
3.22
5.49
5.67
7.3
2.13
-3.94
7.74
5.68
1.91
1.36
0.14
0.14
2.98
1.8
2.21
-8.05
-1.27
1.66
-2.25
-1.34
-3.4
-2.98
0.29
-1.62
-2.22
Statistics
26
Source: eVestment Alliance
1st Quartile –
MSCI World
Median –
MSCI World
3rd Quartile –
MSCI World
Mean
7.4
2.4
-1.4
Median
6.3
2.2
-1.9
Stdev
5.4
3.5
3.2
High
21.0
7.7
4.8
Low
-0.8
-5.3
-8.1
2007
So…..Can Active Managers “Beat the Market?”
Asset Class
Breadth
Skill
Odds of Success
Cdn. Fixed Income
Low
Low
Low
Cdn. Equity
Low
Avg.
Avg.
Cdn. Small Cap
Avg.
High
High
U.S. Equity
High
Avg.
Avg.
U.S. Small Cap
High
High
High
Global Equity
High
High
High
27
Long Term Observations…..
Active vs. Passive Management

Average Manager Return
= Market Return
i.e., Market Return
= Passive Portfolios + Active Portfolios

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
“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
28
Source: The Arithmetic of Active Management: Does Fund Size Matter? Reprinted with permission from The Financial
Analysts' Journal Vol. 47, No. 1, by William Sharpe, January/February 1991. pp. 7-9
Copyright, 1991, Association for Investment Management and Research, Charlottesville, VA
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
• Change vs Shift in Investment Process
• Organizational Uncertainty Challenges
• Success Can Lead to Mediocrity
29
Success Can Lead to Mediocrity
Why?
“Bets” Diminish Over Time Due To:
1. Increase in AUM
2. Increase in Transaction Costs
3. Increase in “Qualified” (CFA Charterholder)
Employees
4. Business Decision
30
•
No Skill
•
Protective Mode
Source: Mutual Fund Performance: Does Fund Size Matter? Financial Analyst Journal, by Daniel C. Indro, Christine X.
Jiang, Michael Y. Hu and Wyne Y. Lee, May 1999, The Evolution of Investment Processes, by Paul Greenwood, Russell
Research Commentary, June 1999.
Alpha Shrinkage As Assets Multiply
“ The real business of money management is not
managing money, it is getting money to manage.
Value
Added
Mark Hurley, Goldman, Sachs and Co.,
Evolution of the Investment Management Industry
Beat the
Market
0
Assets Under Management
Lose to
the
Market
31 Source: Asset Growth and Its Impact on Expected Alpha, by R.Kahn, in Global Perspectives on Investment Management, CFA
Institute, 2006, pages 197 – 212
”
Do We Really Understand Execution?
Commission
5¢ (17bp)
Impact
10 ¢ (34 bp)
Delay
23 ¢ (77 bp)
Missed Trades
9 ¢ (29 bp)
Source: Plexus Group
32
Source: Analyzing Transaction Cost: Part 1: Wayne Wagner and Steven Glass, The Journal of Investment Consulting, June 1999.
The Elephant In The Room
“ 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.
The Economist
March 1, 2008, Special Report on Asset Management
33
”
Meeting the Success Challenge In The Investment
Management Industry
• Investors Will Pay More Attention to Firm’s Business model
• Questions of Capacity will Come up More Frequently
• Capacity Serious Investors Will Employ Performance Based Fees
• This Will Lead More Managers to Focus on Maximizing Alpha as Opposed
to Maximizing Assets
34
Where Is Active Management Going?
• Canadian Equity Plus
• 130/30
• Small Cap
• Market Neutral/Portable Alpha
Why?
The Fundamental Law of Active Investment Management
Plus The Power Of Diversification
35
The Power of Diversification
Contribution to Excess Return/Risk
8
The Greater the Negative Correlation Between 2
Investments, the Greater the Contribution to
Reducing Risk.
7
6
This Relationship is Non- linear.
5
4
3
Short Selling
Portable Alpha
Market Neutral
T-Bills
2
1
0
-0.99
-0.80
-0.61
-0.42
-0.23
-0.04
Long-Bonds
0.15
Correlation
36
0.34
World Equities
0.53
0.72
Cdn. Equities
0.91
The Spectrum of Active Management Strategies
Expected Return
< 18%
Small
Cdn.
Cap
Equity 130/30
Plus
Long
Short
< 10%
Portable
Alpha &
Market
Neutral
Equities
60/40
Long
Bonds
< 5%
T-Bills
< 7%
< 11%
Risk
37
< 16%
Market Neutral Is Also An Excellent Diversifier
Return Correlations From Jan 1994 – June 2008
S&P
TSX
38
S&P
500
MSCI
EAFE
Scotia
Macleod
Universe
CSFB MN
Equity
Index
S&P/TSX*
1.00
S&P 500*
0.63
1.00
MSCI EAFE*
0.59
0.73
1.00
Scotia
Macleod
Universe*
0.18
0.12
0.01
1.00
CSFB
MN Equity
Index
0.06
-0.06
0.03
0.03
1.00
Cdn. 91 Day
T-Bill*
-0.07
0.09
0.00
.02
0.14
* Indices are Total Returns in $Cdn. CSFB Returns are $US
Cdn. 91
Day
T-Bill
1.00
The Active vs. Passive Management Debate
• Most “Traditional” Strategies Still Work
• Index or LDI Canadian Bonds and “Port Alpha on Top” or Accept Less
• “Extension” Strategies Increase the Odds of Success
• Small Cap Can be Big
• Always Consider the Fundamental Law of Active Management
39