The Premature Deathof Alpha

Harry Marmer, CFA, MBA – Executive Vice President416.913.3907/hmarmer@hillsdaleinv.com

“You faked your death once before – how do I know you’re not faking it now?”

Source: The New Yorker

February 9, 2017

The Premature Death of Alpha

• What is Alpha?

• Who Are The Culprits in the Death of Alpha?

• The Three Fundamental Laws Driving the Active/Passive Investment Debate

• The Perversity of Success in Asset Management

• Is Alpha Dead?

2

What Is Alpha?

• Difference in Returns Between The Investment Manager and the Benchmark or Index. Typical Benchmark for Canadian Equities is the S&P/TSX Total Return Index

• Active vs Passive Investment Management Debate,i.e. Can You Beat The Market?

• Alpha is Also Known As:– Value Added– Excess Return

3

“Beating the Market Has Become Nearly Impossible”

OBITUARIES

Alpha is Dead

4 Source: Institutional Investor, Julie Segal, Oct 27 2013; The Death of Alpha On Wall Street, Scott Appleby, Tabb Forum, December 23, 2013

Who Are The Culprits In the “Death of Alpha”?

• Consultants – Too Quick to Replace Managers• Investment Committees – Weak Governance, Spending Majority of Time

On Non-Governance Matters (i.e. Economy, Performance, etc)• Financial Innovation – ETFs Are “Commoditizing” Alpha• Money Managers – Overpromise Performance & Over Simplify Process• Pension Staff – Inexperience Leads To Chasing Hot Performing Managers• Private Equity Firms – Reduce # of Stocks By Taking Companies Private• Regulators & Accountants – Regulation Fair Disclosure*• Sell Side (i.e. Brokers) – HFT – Trading Costs Dramatically Lower• Technology – The Internet – Information is Immediately Disseminated “Each Participant Knows That It Is Working Conscientiously, Knows it is Working Hard, and Believes Sincerely In Its Own Innocence.”1

1 – Charles Ellis., “Murder on the Orient Express: The Mystery of Underperformance.”, (July/August 2012), Financial Analysts Journal, Vol. 68, No. 4. pp: 7. See as well “Death of Alpha On Wall Street” by Scott Appleby, Dec 2013, Tabb Forum.

5*Regulation FD – All publicly traded companies must disclose all material info to all clients at the same time, Aug 2000

“US Active Managers Confounded…”7

Is Active Investment Management Dead? Not A New Concept

6

1 – Makan, Ajay, McCrum, Dan and Mackenzie, Michael., “Start Stock Pickers Struggle to Beat Index”. (Nov 2011). Financial Times. Available Online.2 – AAA Staff., “Stock-Picking Alpha in a Life or Death Struggle”. (Oct 2010). All About Alpha. Available Online.3 – Bianco Research L.L.C. “Why 2011 Was a bad Year for Money Managers”. (Jan 2011). [Conference Call Handout]4 – Goodman, Beverly. “Meet the New Math, Same as the Old Man”. (Mar 2012). Barrons. Available Online. 5 – Cooper, Jay., “Rogercasey Defends Active Managers”. (Sept 2009). FundFire.com. Available Online.6 – Fay, Sharon., “Is Active Management Dead?”, (Oct 2011). Allinace Bernstein Blog. Available Online.7 –Flood, Chris. “US Active Managers Confounded by Correlations”., (Jan 2012). Financial Times. Available Online.8 – Lauricella, Tom and Zuckerman, Gregory. “ ‘Macro’ Forces in Market Confound Stock Pickers”. (Sept 2010). The Wall Street Journal. Available Online.

Active Investment Management Success Varies Over Time

7Source: Peak Passive: The Coming Active Renaissance, by Joe Mezrich, Nomura Quant Strategy, Jan 5, 2017

Three Fundamental Laws Driving The Active/Passive Debate

Three Fundamental Laws Driving The Active/Passive Investment Management Debate

1.The Market Is Driven By Different Factors Over Time

2. Arithmetic Of Active Investment Management

3. The Fundamental Law of Active Investment Management

8

The Market Is Driven By Different Factors Over TimeIn the Short Term, Many Factors Can Drive Market Returns and Influence The Success Of Active Management Irrespective Of Skill:

• Beta• Cap• Commodities• Currencies• Fiscal Policy• Fundamentals• Interest Rates

9 .

• Monetary Policy• Noise• Politics• Risk or Volatility• Speculative• “Style”• Etc…

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

-15%

-10%

-5%

0%

5%

10%

15%

20%

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016

Quarterly Excess Return 1 Year Rolling Excess Return

Cap – Managers Tend to Outperform Russell 2000 TRI - S&P 500 TRI

Quarterly, Mar 1980 – Dec 2016

Small CapOutperforms

Large Cap Outperforms

Qua

rter

ly E

xces

s R

etur

n

1 Ye

ar R

ollin

g E

xces

s R

etur

n

Sources: See Footnote 1.10

Qtrl. 1 Year Rolling

Mean 0.1% -0.3%Median -0.4% -1.0%Stdev 5.2% 11.7%High 15.1% 41.5%Low -15.4% -34.7%

Statistics

Sources: See Footnote 1.11

Risk: Active Management Underperforms When High Risk Wins

-60%

-40%

-20%

0%

20%

40%

60%

80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Standard Deviation 30 days

MeanMedianStDevHighLow

Statistics-3.5%-3.5%14.9%62.9%-46.5%

Rolling 3 Month Return Spread Between High & Low Risk StocksStocks from the S&P/TSX Composite

Jan 1986 – Dec 2016

Risk is measured as 30 Day Standard Deviation of Returns, Top 30 and bottom 30 stocks, 3 Month Rolling Data, Monthly Rebalanced

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Recession Periods and Bear Markets IPC Average VIX VIX

Russell 1000 120 Day Intra-Portfolio Correlation† vs VIXMonthly, Dec 1986 – Dec 2016

12

IPC VIX

6 M

onth

IPC

Mon

th E

ndin

g V

IX

In High Risk Regimes, Stock Correlations Are High and Stock Dispersion is Low

Mean 20.62Median 18.91Stdev 7.97High 61.41Low 9.82

StatisticsMean 0.28

Median 0.26Stdev 0.12High 0.66Low 0.07

StatisticsIPC: 0.18VIX: 14.0

Dec-16

1- Erb, Claude B., Harvey, Campbell R., and Viskanta, Tadas E., “Forecasting International Equity Correlations” (November/December 1994), Financial Analysts Journal, Pages 32 – 45; Campbell, Rachel, Koedijk, Kees, and Kofman, Paul., “Increased Correlation in Bear Markets” (January/February 2002). AIMR, Pages 87-94. Bouchaud; Jean-Philippe, and Potters, Marc., “More Stylized Facts of Financial Markets: Leverage Effect and Downside Correlations” (2001). Physica A, Pages 60-70; Pownall, Rachel A.J., Forbes, Catherine S., Koedijk, Kees C. G. and Kofman, Paul, “Diversification Meltdown or Just Fat Tails?” (June 2006), EFA 2006 Zurich Meetings; Ankrim, Ernest M., and Ding, Zhuaxin., “Cross-Sectional Volatility and Return Dispersion” (September/October 2002), AIMR, Pages 67-73;Weigand, Robert A., Gorman, Larry R. and Sapra, Steven G., “The Cross-Sectional Dispersion of Stock Returns, Alpha and the Information Ratio” (Fall, 2010), Journal of Investing; Bouchey, Paul., Fjelstad, Mary. and Vadlamudi, Hemambara., “Measuring Alpha Potential in the Market” (2011). Journal of Investing. Fall 2011, Vol. 2, No. 2: Pages 40-47.

13

This Law Will Help You Avoid The Performance Trap

The Performance Trap:Selling This Year’s Loser Which Becomes Next Year’s Winner and Buying Last Year’s Winner Which Becomes this Year’s Loser

Source: Perspectives on Institutional Investment Management, by Harry S. Marmer, Rogers Publishing, 2002

-5%-4%-3%-2%-1%0%1%2%3%4%5%6%7%8%9%

-5%-4%-3%-2%-1%0%1%2%3%4%5%6%7%8%9%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Calendar Year Value Added 4 Year Annualized

14

“Active Investment Management Is Usually Called Into Question At Precisely The Wrong Time”

* Data Source: SEI and RBC Dexia. As of December 31, 2015.* Source: In Defense of Active Investment Management, by Chris Thompson, Rogerscasey, September, 2009

RBC Dexia Median Canadian Equity Manager vs. S&P/TSX TRIYearly, 1990 - 2015

2011

1993

2. The Arithmetic of Active Investment Management

Part A.

Market (Index) Return = Passive Portfolios + Active Portfolios

In A Perfect or Efficient Market, The Average or Median Manager Will Approximate the Market or IndexReturn Before Costs

15Source: 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. “Before Costs The Return On The Average Actively Managed Dollar Will Equal The Return On the Average Passively Managed Dollar.”

10%

12%

14%

16%

18%

US Equity Universe

In A Perfect World or Efficient Market, The Median Manager Will Approximate the Index Return Before Costs

16

S&P 500Median Manager

US Equities 5 Year Annualized Return Ending Dec 2013

1st Quartile 15.06

Median 14.29

3rd Quartile 13.71

S&P 500 14.45

Source: Mercer Pooled Fund Survey, December 2013.

1st Quartile

3rd Quartile

2. The Arithmetic of Active Investment Management

Part B.

Market Return ≠ Passive Portfolios + Active Portfolios

In An Imperfect or Inefficient Market, The Average or Median Manager Will NotApproximate the Market or Index Return Before Costs

17 Source – Harry Marmer, The Active vs Passive Debate, Before Costs The Return On The Average Actively Managed Dollar Will Not Equal The Return On the Average Passively Managed Dollar.

How The Arithmetic of Active Investment Management May Not Add Up

• Not All Active Portfolios Are Tracked 1

• Skewed Index, i.e. Narrow, Concentrated• Survivorship Bias 1

• Active Management Tilts Are Rewarded• Bubbles

18 1 – This is discussed in more detail by Manager Selection, by Scott Stewart, Research Foundation of CFA Institute, 2013.

5th Percentile 15.7%1st Quartile 6.9%

Median 5.2%3rd Quartile 1.8%

95th Percentile -0.2%S&P/TSX Small Cap -5.7%

In An Imperfect or Inefficient World, The Median Manager Will Not Approximate the Market

19

Canadian Small/SMID Cap Equities 5 Year Annualized Returns Ending Dec 2015

Source: Mercer Pooled Fund Survey, December 2015.

-6.0%

-3.0%

0.0%

3.0%

6.0%

9.0%

12.0%

15.0%

18.0%

TSX Small Cap

Cdn Small/SMID Cap

Median Manager

What Is Skill?

20 Source: Scott D. Steward. “Manager Selection”, (December 2013), Research Foundation of CFA Institute, Page 32.

Key Characteristics of Successful Investment Managers

Factor1 Intelligence2 Knowledge3 Focus4 Long-Term Thinking5 Independent Thinking6 Alignment of Interests

“Active Management Is Hard”*

*The Great Divide over Market Efficiency, 03 MAR 2014 - Clifford Asness, John Liew, Institutional Investor, March 2014, The Great Divide Over Market Efficiency

21

-4

-3

-2

-1

0

1

2

3

4

-4

-3

-2

-1

0

1

2

3

4

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Median Manager

22

Canadian Fixed Income: Easy or Hard To Beat?

*Based on median manager returns.Source: Hillsdale Investment Management, Mercer Investment Consulting Pooled Fund Survey, $Cdn. As of Dec 31, 2016. Updated January 30, 2017.

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

Annualized Since Inception*

0.1%

1st Quartile – DEX Median – DEX 3rd Quartile –

DEX

Mean 0.7 0.1 -0.5Median 0.5 0.0 -0.4Stdev 0.7 0.6 0.6High 3.8 2.6 0.9Low -0.2 -1.4 -2.6

Statistics

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016% of Managers Outperforming 32% 64% 50% 66% 78% 24% 69% 28% 56% 53% 32% 71% 67% 55% 73% 48% 65% 55% 42% 53% 70% 26% 23% 89% 77% 20% 89% 79% 42% 48% 83%

Mean 56%Median 55%Stdev 20%High 89%Low 20%

Statistics% of Managers Outperforming

-25

-20

-15

-10

-5

0

5

10

15

20

25

-25

-20

-15

-10

-5

0

5

10

15

20

25

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Median

23

Canadian Fixed Income: Very Hard To Beat

*Based on median manager returns.Source: Hillsdale Investment Management, Mercer Investment Consulting Pooled Fund Survey, $Cdn. As of Dec 31, 2016. Updated January 30, 2017.

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

Annualized Since Inception*

0.1%

1st Quartile – DEX Median – DEX 3rd Quartile –

DEX

Mean 0.7 0.1 -0.5Median 0.5 0.0 -0.4Stdev 0.7 0.6 0.6High 3.8 2.6 0.9Low -0.2 -1.4 -2.6

Statistics

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016% of Managers Outperforming 32% 64% 50% 66% 78% 24% 69% 28% 56% 53% 32% 71% 67% 55% 73% 48% 65% 55% 42% 41% 70% 13% 23% 89% 77% 20% 89% 79% 42% 48% 83%

LegendMedian Mean 56%

Median 55%Stdev 20%High 89%Low 20%

Statistics% of Managers Outperforming

24

Cdn Small Cap Equities: High Skill, Plenty of Opportunities

*Based on median manager returns.Source: Hillsdale Investment Management, eVestment Alliance. As of Dec 31, 2016. Updated February 1, 2017.

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

-20

-15

-10

-5

0

5

10

15

20

25

-20

-15

-10

-5

0

5

10

15

20

2519

90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Median - S&P/TSX Small Cap

Annualized Since Inception

4.4%

QS&P/TSX Small Cap

S&P/TSX Small Cap

Q– S&P/TSX Small Cap

Mean 11.2 5.2 -0.2Median 14.0 7.9 1.8Stdev 8.6 8.3 8.2High 26.9 23.4 16.2Low -11.6 -16.9 -19.5

Statistics

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016% of Managers Outperforming 88% 74% 100% 66% 44% 43% 79% 76% 33% 9% 78% 77% 73% 41% 78% 78% 77% 76% 66% 33% 23% 84% 94% 100% 88% 91% 6%

Mean 66%Median 76%Stdev 27%High 100%Low 6%

Statistics% of Managers Outperforming

25

Why Can Alpha Shrink Over Time?

1. “Active” Bets Diminish Over Time

2. Skills Are No Longer “Skills”

3. Increase in AUMi. Transaction Costs “Creep Up”ii. # of Securities Increaseii. Hire More Professionals– Increase in Securitiesiii. Higher Administrative Stressiv. Deviation from Style

4. Lifecycle of A Business, i.e. Business Decisions• No Skill• Protective Mode, i.e. “Guardian” Mentality

Sources: 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.

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Listed Companies Mutual Funds CFA Charter Holders

As AUM Increases, More Professionals Are Hired, More Administrative Care Is Required

26 Source of Data: CFA Institute, World Federation of Exchange

Number of CFA Charter Holders vs. Number of Stocks & Mutual Funds

Exponential Growth

Key Takeaways • Alpha (Value Added) Is Not Dead

• Any Assessment Of The Success of Active Management Should Always Consider:– The Factors Driving Stock Returns– The Benchmark Representing the Investment Opportunity Set– The Odds of Beating The Market

• Both Active and Passive Investment Management Success Is Cyclical i.e. Go In And Out Of Favor Over Time

• The Dynamics Of Winning In Active Investment Management Vary Over Time.

• These Variabilities Reflect Both The Complexity and Dynamics Of The Market

• Significant Value Added Can Be Gained In Select Asset Classes But Success Will Depend on Manager Breadth, Skill and the Market

• To Temper the “Quest for Mediocrity” Clients Can Align Their Managers with Well Designed Incentive Based Fees

27 Source: “Empirical Evidence Indicates a Positive Correlation Between the Inclusion of Performance Based Fees and Higher Alphas…” page 69 in Manager Selection by Scott Stewart, Research Foundation of the CFA Institute, 2013.

Appendix

28

29

Managers in Top Quartile

2008 2009 2010 2011 2012

4 2 1 0

Source: Hillsdale Investment Management, eVestment Alliance. Manager universe is based on eVestment’s All Canadian Equity Universe.

51

Chasing Performance

1 Year Of Past Performance Has NOPredictive Power

Law #1 Suggests That It is Very Challenging For Active Managers To Stay Consistently in First Quartile

Institutional Managers Outperform

• “Using a dataset of $17 trillion of assets under management, we document that actively managed institutional accounts outperformed strategy benchmarks by 86 (42) basis points gross (net) during 2000–2012. In return, asset managers collected $162 billion in fees per year for managing 29% of world capital.

• We trace this outperformance to systematic deviations from the asset-class benchmarks. The asset manager industry is therefore not just a passive pass-through entity…”

Source: “Institutional Performance and Smart Betas” by Joseph GerakosJuhani T. Linnainmaa Adair Morse, November 28, 2016

“We Find That the Average Mutual Fund Has Used This Skill to Generate About $3.2 Million Per Year.”• “The total value the manager extracts from markets is equal to the amount of

money the fund charges in fees, minus any money it takes from investors: the percentage fee multiplied by AUM plus the product of the return to investors in excess of the benchmark and AUM. This quantity is the fund’s gross excess return over its benchmark multiplied by assets under management, what we term the value added of the fund.”

• “Investors appear to be able to identify talent and compensate it: current compensation predicts future performance.”

• Not only do better funds collect higher aggregate fees, but current aggregate fees are a better predictor of future value added than past value added”

• To measure skill we take “the product of the fund’s abnormal return (the return before fees minus the benchmark return) and assets under management (AUM)

Source: Measuring Skill in the Mutual Fund Industry,” by Jonathan Berk and J. van Binsbergen, Journal of Financial Economics, 2015, vol. 118, issue 1, pages 1-20

44

32

Harry S. MarmerHarry S. Marmer, BBA, MBA, CFA, Partner. Prior to joining Hillsdale in 2008, Mr. Marmer led the Canadian institutional business of Franklin Templeton Investments and before that the institutional business at Russell Investment Group. He was also a principal and co-leader of Mercer's Canadian Investment Consulting Practice. Before this he was a Senior Investment Analyst at Sun Life Canada. Mr. Marmer is a frequent conference speaker and has authored more than 49 articles and a book entitled, "Perspectives in Investment Management." Currently, he continues to volunteer for the CFA Institute and is a member of the Investment Committee of the Canadian Friends of Hebrew University. Mr Marmer has served on a number of industry boards and was past president of the Toronto CFA Society. He was awarded the Toronto CFA Society’s Research Award and received the Society’s Volunteer of Distinction Award