Active versus Passive ManagementSeptember 13th, 2015 - LAPERSDarren Fournerat, CFA, CAIALaney 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

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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?

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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

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Spectrum of Portfolio Management

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Index Fund

Enhanced Indexing / Semi active

Long Only Benchmark constrained Long / Short Hedge Funds

Passive

Active

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 software6

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

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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

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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?

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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

10*Source - The Arithmetic of Active Management” by William Sharpe

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

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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

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Opportunities for Outperformance

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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

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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

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Smart Beta – Growth and Popularity

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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

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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

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Smart Beta – What is holding it back?

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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

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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

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