Revisiting Active vs. Passive Moving Beyond the Data-Driven Framework 2015 NCPERS Trustee Educational Seminar (TEDS) May 2, 2015

• In general, we believe there are opportunities to add value through active investment decision-making

NEPC Approach: • We seek to help clients build the most efficient portfolio that meets

their unique risk and return objectives • We believe that, over time, there will exist opportunities to improve

performance through superior strategy, structure, and implementation

• We seek to add value to client decision-making at each step in the

process: – Asset allocation – Portfolio structuring and positioning – Investment selection and monitoring

Active vs. Passive - Introduction

1

• We believe it is critical to focus key decisions and allocate resources consistent with the opportunity to add value

• Scarce resources for an investment program:

– Capital – Market risk budget – Active risk budget – Management fees – Time - Board, Committee, Staff, Consultant

NEPC Investment Philosophy - Active vs. Passive

2

A Challenge of Investment Program Management

Asset Allocation

Portfolio Structuring & Positioning

Manager Selection and Monitoring

Impact on Program (Risk and Return)

Typical Time Allocation

3

• NEPC believes there is no one “right” answer – Depends on investment program characteristics

• Available resources – time, active risk, management fees • Governance structure in place to:

• Seek excess return in all components of plan structure • Be patient with short-term underperformance

– Depends on asset class • Focus active risk, management fee, and time budget on:

• Most inefficient markets • Less constrained mandates

– Depends on market environments • Active and passive management involve biases that will drive periods of over- and under-

performance

Active vs. Passive Management

4

• Difficult to draw hard and fast conclusions despite many analyses performed over the years

• Analytical challenges include:

– Universe selection – Survivorship bias – Time period sensitivity

• Analyses can be created to prove the case of the interested party • Recommend taking retrospective analyses with a “grain of salt” • Test intuitively consistent hypotheses • Be wary of secular extremes that can lead to wrong conclusion at

worst time

Active vs. Passive Analyses

5

Depends on asset class

• Active management performs well in less efficient markets – Less constrained – Larger heterogeneous opportunity sets – Diverse opportunity sets in markets allow for active management to seek alpha – Examples: Small Cap, Non-US Markets

• Passive index options are more likely to add value in efficient markets

– More constrained – Smaller homogenous opportunity set, well researched – Examples: US Large Cap

Annual Index Rankings by Investment Category

Methodology: Passive Blended Portfolio constructed as 30% Large Cap Core, 10% Small Cap Core, 15% International Equity, 5% Emerging Market Equity, 40% Core Fixed Income. The Blended Portfolio ranking is calculated by taking the weighted average of the underlying asset class index ranks. 1 = Best, 100 = Worst

Source: eVestment

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Large Cap Core S&P 500 86 68 68 47 61 78 40 70 64 54 41 44 40 58 38Small Cap Core Russell 2000 87 68 78 37 69 81 24 66 40 70 57 74 59 62 56International Equity MSCI EAFE 66 68 65 56 54 75 58 55 49 62 83 55 76 62 68Emerging Equity MSCI EM 77 63 79 75 59 65 64 54 48 58 66 52 71 74 69Fixed Income Barclays Aggregate 62 59 49 68 61 75 70 42 33 84 75 43 90 80 53

Passive Blended Portfolio 73 64 62 57 61 76 54 55 46 69 64 49 69 69 52

Active Underperforms Active Outperforms

6

Depends on investment program characteristics

Methodology: Passive Blended Portfolio constructed as 30% Large Cap Core, 10% Small Cap Core, 15% International Equity, 5% Emerging Market Equity, 40% Core Fixed Income. The Blended Portfolio ranking is calculated by taking the weighted average of the underlying asset class index ranks.

Active Underperforms

Active Outperforms

Ranking

• The past year was a more challenging one for active management

– Over the past 15 years, the Passive Blended Portfolio ranked in the top half vs. peers only 2 times

• A change in market environment could lead to a better performance from active managers

– Market headwinds or heightened volatility can provide a better opportunity for active managers

Passive Blended Portfolio Ranking

1 = Best, 100 = Worst Source: eVestment

7

• Evaluated performance of active managers over rolling 1, 3, and 5-

year periods ending 12/31/14 – Net of fees* – Attempts to minimize “survivorship bias”, particularly over one and three year periods

• Evaluated ranking of indexes in universe over calendar year periods – Net of fees* – Attempts to minimize “survivorship bias”

• Used data from eVestment Alliance for 2012 and after.

– Encompasses over 10,000 investment products, 1,900 different investment firms – Industry’s largest provider or traditional and hedge fund data – Data prior to 2012 is from the Independent Consultants Cooperative universe

Active vs. Passive Analysis – Data

* Fees from 2008 eVestment Alliance manager fee study; used fee for $25 million mandate

8

U.S. Large Cap Core Equity – Rolling Periods

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median large cap core equity manager has outperformed the S&P 500, net of fees¹, in:

- 36 of 91 rolling one-year periods (or, 40% of the time) - 35 of 83 rolling three-year periods (or, 42% of the time) - 43 of 75 rolling five-year periods (or, 57% of the time)

9

U.S. Large Cap Core Equity – Benchmark Rank

The S&P 500 ranked below median 6 out of the last 15 years ¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

Perc

entil

e Ra

nk

10

U.S. Large Cap Growth Equity – Rolling Periods

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median large cap growth equity manager has outperformed the Russell 1000 Growth, net of fees¹, in:

- 38 of 92 rolling one-year periods (or, 41% of the time) - 38 of 85 rolling three-year periods (or, 45% of the time) - 42 of 77 rolling five-year periods (or, 55% of the time)

11

U.S. Large Cap Growth Equity – Benchmark Rank

The Russell 1000 Growth ranked below median 7 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

12

U.S. Large Cap Value Equity – Rolling Periods

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median large cap value equity manager has outperformed the Russell 1000 Value, net of fees¹, in:

- 37 of 88 rolling one-year periods (or, 42% of the time) - 43 of 84 rolling three-year periods (or, 51% of the time) - 41 of 76 rolling five-year periods (or, 54% of the time)

13

U.S. Large Cap Value Equity – Benchmark Rank

The Russell 1000 Value ranked at or below median 9 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

14

U.S. Small Cap Core Equity – Rolling Periods

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median small cap core equity manager has outperformed the Russell 2000, net of fees¹, in:

- 49 of 76 rolling one-year periods (or, 64% of the time) - 57 of 66 rolling three-year periods (or, 86% of the time) - 55 of 58 rolling five-year periods (or, 95% of the time)

15

U.S. Small Cap Core Equity – Benchmark Rank

The Russell 2000 ranked below median 10 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

16

U.S. Small Cap Growth Equity – Rolling Periods

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median small cap growth equity manager has outperformed the Russell 2000 Growth, net of fees¹, in:

- 47 of 81 rolling one-year periods (or, 58% of the time) - 56 of 73 rolling three-year periods (or, 77% of the time) - 53 of 64 rolling five-year periods (or, 83% of the time)

17

U.S. Small Cap Growth Equity – Benchmark Ranks

The Russell 2000 Growth ranked below median 7 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

18

U.S. Small Cap Value Equity – Rolling Periods

Active Outperforms

Passive Outperforms

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median small cap value equity manager has outperformed the Russell 2000 Value, net of fees¹, in:

- 44 of 65 rolling one-year periods (or, 68% of the time) - 44 of 57 rolling three-year periods (or, 77% of the time) - 45 of 49 rolling five-year periods (or, 92% of the time)

19

U.S. Small Cap Value Equity – Benchmark Ranks

The Russell 2000 Value ranked below median 7 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

20

International Equity – Rolling Periods

Passive Outperforms

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median international equity developed manager has outperformed the MSCI EAFE, net of fees¹, in:

- 67 of 92 rolling one-year periods (or, 73% of the time) - 85 of 92 rolling three-year periods (or, 92% of the time) - 92 of 92 rolling five-year periods (or, 100% of the time)

21

International Equity – Benchmark Ranks

MSCI EAFE ranked below median 11 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

22

Emerging Markets – Rolling Periods

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median international equity emerging market manager has outperformed the MSCI EM Market, net of fees¹, in:

- 36 of 85 rolling one-year periods (or, 42% of the time) - 42 of 77 rolling three-year periods (or, 55% of the time) - 48 of 69 rolling five-year periods (or, 70% of the time)

23

Emerging Markets – Benchmark Ranks

MSCI EM Index ranked below median 5 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

24

Domestic Fixed Income – Rolling Periods

¹ Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance. The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used. ² The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

The median domestic fixed income manager has outperformed the BC Aggregate, net of fees¹, in:

- 53 of 92 rolling one-year periods (or, 58% of the time) - 53 of 92 rolling three-year periods (or, 58% of the time) - 53 of 88 rolling five-year periods (or, 60% of the time)

25

Domestic Fixed Income – Benchmark Ranks

BC Aggregate ranked at or below median 9 out of the last 15 years

Perc

entil

e Ra

nk

¹ eVestment and ICC universes shown. Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark. For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

26

• Data appear broadly consistent with intuitive hypotheses: – US Large cap stock managers exhibit lowest probability of active management

outperformance; margins are relatively tight – Small cap, Non-US stocks exhibit higher probability of active management

outperformance; margins are wider • Emerging markets stocks are an outlier – requires further consideration

– Core fixed income demonstrated modest outperformance until big fall-off in 2008 followed by rebound in 2009 and 2010

• Success of active management can appear cyclical

– Can be based on relative trends of performance related to biases of active strategies versus indexes

– Lower probability of active management success in short-term periods does not preclude longer-term success

– Trending nature of active management success indicates some alpha may be disguised beta • Example of fixed income – 2008 vs. 2009

Active vs. Passive – Observations

27

Asset ClassMarket

EfficiencyDiversity of

Opportunity SetActive

ConstraintsExcess Return

ExpectationEase of Indexing Comments/Recommendation

US Large Cap Stocks High Low High Low High

Most obvious choice for indexing (and /or portable alpha)

US Small Cap Stocks Moderate Moderate Moderate Moderate Moderate

In general seek active; can index core exposure

Non-US Developed Market Stocks Moderate Moderate High Moderate Moderate

In general seek active; can index core exposure

Emerging Market Stocks Moderate Moderate Moderate Moderate Moderate

In general seek active; can index core exposure

Core Bonds (Gov't/Credit) High/Moderate Low/Moderate High Low / Moderate Moderate

Evaluate index components; potentially seek active in less efficient sectors

Emerging Market Bonds Moderate Moderate Moderate Moderate Low Seek active

High Yield/Bank Loans Low High Moderate Moderate Low Seek active

Hedge Funds Low High Low High LowHedge fund beta replication emerging, but unproven; seek active

Private Equity Low High Low High N/A Must use active

Real Estate Low High Low High N/A Must use active

Active vs. Passive – Summary by Asset Category

28

• We believe in seeking to add value at every step in the investment management process

– Asset allocation – Portfolio structuring and positioning – Active portfolio management

• It is critical for plan sponsors to focus resources on the highest value-added components of the investment management process

• Active management is more likely to add value in less-efficient areas

of the capital markets

• Active management is less likely to add significant value in more efficient areas of the capital markets

– These areas may be candidates for indexing or portable alpha solutions

• Relative performance of active and passive management can appear cyclical

– Example of fixed income in 2008-9; may lead to re-evaluation of fixed income benchmarks and strategies

Summary

29

• Universe data prior to 2012 was provided by the Investment Consultants Cooperative universe. Universe data for 2012 and after was provided by eVestment Alliance.

• Annualized net-of-fee results are calculated by subtracting the average manager fee, respective of asset class and style, from the eVestment or ICC gross-of-fee performance.

• The average manager fees used prior to 2009 were obtained from the 2008 eVestment Alliance manager fee study. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

• The universe data shown includes only actively managed portfolios. The minimum sample size used for each time period is 20 portfolios.

• Benchmark rankings are relative to the respective actively managed gross-of-fee universe. Rankings reflect the gross-of-fee results of the benchmark.

• For periods prior to 2009 results were calculated by adding the respective asset class and style annual fee as obtained from the 2008 eVestment Alliance manager fee study to the annual benchmark return. For periods after to 2009, the 2009 eVestment Alliance manager fee study was used.

• Past performance is no guarantee of future results. • Data used to prepare this report was obtained directly from various sources. While NEPC has exercised reasonable

professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within.

Disclaimer

30