The Active vs. Passive Investment Debate

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Nov 18, 2013 (3 years and 4 months ago)

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The Active vs. Passive Investment Debate

Discussion on:

The Rewards and Risks of Active vs. Passive Investment Management

Harry Marmer, CFA, MBA


Executive Vice President, Hillsdale Investment Management

On the One hand…..

…..
And on the Other Hand

2

Agenda



Are Markets Efficient?



Can Managers Add Value?



Where is Active Management Going?

3

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)

4

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/TSX
Composite Index


5

Market Timing Track Record


Low Odds Strategy

North American Value Added Experience

Asset Mix Timing Security Selection

Average Annual Value Added

Source: The Portable Pension Fiduciary: A Handbook for Better Pension Fund Management

(Toronto: Benefits Canada, 1997 page 62) , by John Ilkiw

6

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

*Source: Bill Sharpe, “Likely Gains from Market Timing” Financial Analyst Journal (March/April 1975, Pg 60
-
69)

7

Active vs. Passive Investment Management

Security Selection

Issues to Consider
:

Philosophical

Is the Market Efficient?

Practical

Can Active Managers

“Beat the Market?”

8

A. Philosophical: Is the Market Efficient?

What Does This Mean?

1.
Investors Earn Returns Commensurate with
Risk, ie.,
No Free Lunch


2.
Various Forms of Theory:



Weak



Semi
-
Strong



Strong

Eugene Fama (1965)

Efficient Market =

Securities Reflect All Available Information

9

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

10

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

11

Proliferation of Databases and Software

12

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

13

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



A.I., Neural Net



TAA


Forecast Returns (Fama)

3.

Bounded Market Efficiency



Professional vs. Noise Traders


(ie, Banks, Individuals, the Herd)



Fads, Bubbles, etc

14

The Market is Efficient?



Date

Percentage Change

New York Times Explanation

1

19
-
Oct
-
87

-
20.47%

Worry over dollar decline and trade deficit; Fear of US not supporting dollar

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

*Source: Hillsdale Investment Management Inc.

*Source: NBER Working Paper No. 2538, “What Moves Stock Prices?”, by David Cutler, James Poterba, and Lawrence Summers, Marc
h 1
988. In “Events

That Shook The Market”, Roy C. Fair found that “many large stock price changes have no events associated with them” , Page 7
13,

Journal of Business 2002

**Source: Page 217, Chapter 13, World Events That Impact Financial Markets, “Stocks for the Long Run”, Jeremy J. Siegel,

Less than 25% of Major Moves can be Attributed to a Specific World

Political or Economic Event**

Postwar Movements in S&P Index and Their Causes*

.

.

.

.


.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

15

B. Can Active Managers “Beat the Market”

Active

Passive

16

The Secret Formula of Active Investment Management

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

Information Ratio = Manager’s Skill
×

√ Breath

Relationship Between
Forecasts and Actual
Outcomes

Information Ratio

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

= Standard Deviation of Excess Return

17

In Other Words, Smart Managers Count Cards

18

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

19

-1.6
-1.2
-0.8
-0.4
0.0
0.4
0.8
1.2
1.6
Excess Return (%)
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
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
How Have Active Canadian Bond Managers Faired?

Data Source: Mercer Investment Consulting Pooled Fund Survey

Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. Scotia Capital Universe

20

0.93
0.76
0.48
0.96
0.75
0.63
0.88
0.59
0.57
0.82
0.60
0.72
0.32
0.38
0.38
0.31
0.63
0.39
0.29
0.26
0.30
-0.42
-1.51
-0.55
-0.24
-0.49
-0.70
-0.40
-0.81
-0.81
-0.58
-0.50
-0.41
-0.26
-0.45
-0.20
-0.45
-0.55
-0.36
-0.39
-0.24
-0.17
-0.50
0.12
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Spread (%)
1st Quartile - Median
3rd Quartile - Median
Tough to Sell Active Canadian Fixed Income

Data Source: Mercer Investment Consulting Pooled Fund Survey

1st Quartile
-

Median:

Mean (1998
-
2007) = 0.34

3rd Quartile
-

Median:

Mean (1998
-
2007) =
-
0.36

1st Quartile
-

Median:

Mean (1986
-
1997) = 0.72

3rd Quartile
-

Median:

Mean (1986
-
1997) =
-
0.62

Annual Spread (%) Between Canadian Fixed Income Managers:

1st Quartile vs. Median and 3rd Quartile vs. Median

21

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


22

-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
Excess Return (%)
1st Quartile - TSX
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 - TSX
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 - TSX
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
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
How Have Canadian Equity Managers Faired?

Statistics



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

Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. S&P/TSX Composite

1st Quartile
-

TSX

Mean (1990
-
1998) = 4.9

3rd Quartile
-

TSX:

Mean (1990
-
1998) =
-
1.5

1st Quartile
-

TSX

Mean (1999
-
2002) = 11.9

3rd Quartile
-

TSX:

Mean (1999
-
2002) =
-
1.9

1st Quartile
-

TSX

Mean (2003
-
2007) = 2.7

3rd Quartile
-

TSX:

Mean (2003
-
2007) =
-
2.7

Source: eVestment Alliance

23

-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
Excess Return (%)
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
Median - 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
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
How Have Canadian Small Cap Equity Managers Faired?

Statistics



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

Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. S&P/TSX Small Cap Index

Source: eVestment Alliance

24

-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
Excess Return (%)
1st Quartile - S&P 500
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
Median - 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
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
How Have U.S. Equity Managers Faired?

Statistics



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

Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. S&P 500 Index

1st Quartile


S&P 500

Mean (1990
-
1997) = 4.4

3rd Quartile


S&P 500:

Mean (1990
-
1997) =
-
2.8

1st Quartile


S&P 500

Mean (1998
-
2001) = 11.3

3rd Quartile


S&P 500:

Mean (1998
-
2001) =
-
6.8

1st Quartile


S&P 500

Mean (2002
-
2007) = 5.1

3rd Quartile


S&P 500:

Mean (2002
-
2007) =
-
2.5

Source: eVestment Alliance

25

-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
Excess Return (%)
1st Quartile - Russell 2000
16.5
22.2
4.0
5.8
6.4
12.6
12.0
11.5
8.8
25.6
25.6
15.5
11.1
4.5
5.1
6.7
0.8
11.2
Median - Russell 2000
9.5
4.6
-0.6
1.4
3.2
3.4
7.3
4.6
1.3
-0.9
16.1
4.8
4.0
-1.6
1.0
3.3
-2.9
3.2
3rd Quartile - Russell 2000
3.9
-4.6
-6.1
-4.2
-0.1
-2.9
1.6
-3.0
-3.0
-15.3
3.1
-7.6
-5.0
-7.2
-4.4
0.5
-6.9
-2.5
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
How Have U.S. Small Cap Equity Managers Faired?

Statistics



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

Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. Russell 2000 Index

1st Quartile


R2000

Mean (1990
-
1998) = 11.1

3rd Quartile


R2000:

Mean (1990
-
1998) =
-
2.0

1st Quartile


R2000

Mean (1999
-
2001) = 22.2

3rd Quartile


R2000:

Mean (1999
-
2001) =
-
6.6

1st Quartile


R2000

Mean (2002
-
2007) = 6.6

3rd Quartile


R2000:

Mean (2002
-
2007) =
-
4.3

Source: eVestment Alliance

26

-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
Excess Return (%)
1st Quartile - MSCI World
11.38
7.38
10.96
15.61
-0.75
2.38
6.84
7.2
1.94
20.97
13.86
5.69
4.74
4.19
3.22
5.49
5.67
7.3
Median - MSCI World
6.85
3.54
6.36
5.54
-5.26
0.08
4.7
2.13
-3.94
7.74
5.68
1.91
1.36
0.14
0.14
2.98
1.8
2.21
3rd Quartile - MSCI World
4.78
-2.76
2.93
-0.09
-6.41
-3.62
3.3
-2.94
-8.05
-1.27
1.66
-2.25
-1.34
-3.4
-2.98
0.29
-1.62
-2.22
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
How Have Global Equity Managers Faired?

Statistics



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

Annual Excess Returns (%) of 1st Quartile, Median and 3rd
Quartile Managers vs. MSCI World Index

1st Quartile


S&P 500

Mean (1990
-
1997) = 7.6

3rd Quartile


S&P 500:

Mean (1990
-
1997) =
-
0.6

1st Quartile


S&P 500

Mean (1998
-
2001) = 10.6

3rd Quartile


S&P 500:

Mean (1998
-
2001) =
-
2.5

1st Quartile


S&P 500

Mean (2002
-

2007) = 5.1

3rd Quartile


S&P 500:

Mean (2002
-

2007) =
-
1.9

Source: eVestment Alliance

27

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

28

Long Term Observations…..


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

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

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

29

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


30

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


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.

31

Alpha Shrinkage As Assets Multiply

Source:
Asset Growth and Its Impact on Expected Alpha
, by R.Kahn, in Global Perspectives on Investment Management, CFA
Institute, 2006, pages 197


212

The real business of money management is not
managing money, it is getting money to manage.

Mark Hurley
, Goldman, Sachs and Co.,



Evolution of the Investment Management Industry





Value
Added

0

Assets Under Management

Beat the
Market


Lose to
the
Market


32

Do We Really Understand Execution?

Commission

5¢ (17bp)


Impact

10 ¢ (34 bp)

Delay

23 ¢ (77 bp)

Missed Trades

9 ¢ (29 bp)

Source: Plexus Group

Source:
Analyzing Transaction Cost: Part 1
: Wayne Wagner and Steven Glass, The Journal of Investment Consulting, June 1999.

33

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

34

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


35

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

36

The Power of Diversification

0
1
2
3
4
5
6
7
8
-0.99
-0.80
-0.61
-0.42
-0.23
-0.04
0.15
0.34
0.53
0.72
0.91
The Greater the Negative Correlation Between 2
Investments, the Greater the Contribution to
Reducing Risk.

This Relationship is
Non
-

linear.

Contribution to Excess Return/Risk

Correlation

Short Selling

Portable Alpha

Market Neutral

T
-
Bills

Long
-
Bonds

Cdn. Equities

World Equities

37

Expected Return

Risk

< 10%

< 18%

< 5%

Long

Bonds

T
-
Bills

60/40

Long

Short

< 7%

< 11%

< 16%

The Spectrum of Active Management Strategies

Portable


Alpha &

Market

Neutral

Equities

Small


Cap

130/30

Cdn.

Equity

Plus

38

Market Neutral Is Also An Excellent Diversifier

Return Correlations From Jan 1994


June 2008



S&P

TSX

S&P

500

MSCI

EAFE

Scotia

Macleod

Universe

CSFB MN

Equity

Index

Cdn. 91

Day

T
-
Bill

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


1.00


* Indices are Total Returns in $Cdn. CSFB Returns are $US

39

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