Rethinking the debate activepassive

Executive SummaryActive and passive investments do not need to be mutually exclusive. Just as allocations to thedeveloped and new growth markets, or to equities and bonds, can be complementary, we believethat active and passive investments can serve different needs in the same portfolio. Over the pastdecade, we have seen periods of extreme macro-driven equity performance, the proliferation ofindex investment options and numerous articles favoring passive management. Increasingly,investors have been presented with the argument—why not just go passive? While we believethat passive investing has its benefits there are several variables, such as time horizon andindex distortion, that investors should consider before making a decision. In our view,investors seeking to make a strategic allocation to equities should obtain a more nuancedunderstanding of both active and passive approaches to determine their optimal investmentstrategy.

How we define and measure active managers is critical to evaluating performance. Severalarguments supporting passive investing might change significantly when investors considerthe following:

I. Assessing active management in the appropriate contextWe believe investors should define active as more than “not passive,” and excludeenhanced index funds and “closet” index funds. In addition, we advocate employing the“active share” concept to identify the better-than-average manager. Lastly, we believe anextended time horizon is critical in assessing the benefit of active management.

II. Costs and risks of passive investingTracking error and fees for passive investments can be significant. In addition, volatilityand the distortion of the indexes impose risk and can lead to substantial variance dragfrom down markets.

III. Impact of market environmentsWe expect to see a favorable environment for active management going forward. We believe greater company differentiation and stock-level dispersion, particularly betweenhigh- and low-quality stocks, will create a fertile environment for active management. Inaddition, the impact of active management can be greater during periods of lower returns.

STEVEN BARRY, CIOGSAM FUNDAMENTAL EQUITYNOVEMBER 2010

Re-thinking the Active vs. Passive Debate

PerspectivesInsights on Today’s Investment Issues

This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation tobuy or sell securities.

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Perspectives | Rethinking the Active vs Passive Debate

2 | Goldman Sachs Asset Management

1 “How Active is Your Manager? A New Measure that Predicts Performance,” by Martijn Cremers and Antti Petajisto of the International Center forFinance at the Yale School of Management, January 2007.

2 “Active Share and Mutual Fund Performance,” by Antti Petajisto of the NYU Stern School of Business, September 2010.

Assessing Active Management in the Appropriate ContextDefining passive investing is easy. Essentially, it is the replication of an index or benchmark.Active investing, however, is more difficult to define. Many investors, we believe, immediatelyconnote active investing with portfolio managers and teams of analysts using fundamentalanalysis to make stock decisions. Yet, many of the analyses of active management apply anextremely liberal definition: not passive. Therefore, many of the funds used in these studiesinclude enhanced index funds, which seek to optimize returns largely based on an index-likeportfolio, or “closet” index funds—theoretically making active portfolio decisions but takingvery little risk in practice. Intuitively, these funds will not be able to generate returns above theindex because they essentially are the index. Layer on fees, and they are certain to underperform.Pooling the results of these funds with the returns of truly active managers dampens the overallresults and masks the performance of the real active managers.

The evidence suggests that truly active and skilled managers can and do generate returns abovethe market net of fees. We suggest a look at the study, entitled “How Active is Your Manager? A New Measure that Predicts Performance,” by Martijn Cremers and Antti Petajisto of theInternational Center for Finance at the Yale School of Management1 as well as the recentlypublished follow-up “Active Share and Mutual Fund Performance,”2 from Antti Petajisto inSeptember 2010. In the original paper, Cremers and Petajisto differentiate between the varioustypes of active equity managers using data from 2,650 funds between 1980 and 2003, whilePetajisto extends the analysis through 2009. Furthermore, as suggested in the title of their paper,the authors not only propose a way to measure the “activeness” of a manager, called “activeshare,” but also prove the link between truly active managers and superior performance.

Active share

By definition, active share is the percent of the portfolio that differs from the benchmark. Whilean index fund would have an active share of 0%, the authors find that a truly active portfolioshould range from 60-100%. Cremers and Petajisto conclude that “active management, asmeasured by active share, significantly predicts fund performance. Funds with the highest activeshare outperform their benchmarks both before and after expenses, while funds with the lowestactive share underperform after expenses.” In the follow-up study, which includes data through2009, and captures the impact of the financial crisis, Petajisto similarly concludes that:

“ . . . the most active stock pickers have been able to add value to their investors, beating thebenchmark indices by about 1.26% per year after all fees and expenses . . . . Closet indexershave essentially just matched their benchmark index performance before fees, which hasproduced consistent underperformance after fees. Economically, this means that there are someinefficiencies in the market that can be exploited by active stock selection.”

Exhibit 1a is an excerpt from Petajisto’s follow-up analysis and details the gross and net returnsof the most active managers, which he describes as stock pickers, moderately active managersand closet indexers. He uses data from 1990 through 2009, having concluded that closetindexing was rare prior to this time.

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Goldman Sachs Asset Management | 3

Exhibit 1a: Active stock picking outperforms closet indexing over the last 20 years

Category Active Share Gross Return Net ReturnStock Pickers (High Active Share) 97% 2.61% 1.26%

Moderately Active (Moderate Active Share) 83% 0.82% -0.52%

Closet Indexers (Low Active Share) 59% 0.44% -0.91%

Difference between Stock Pickers and Closet Indexers 2.17% 2.17%

Source: “Active Share and Mutual Fund Performance,” by Antti Petajisto of the NYU Stern School of Business, September 2010. Data reflectsannualized performance of US all-equity mutual funds from 1990-2009. Gross returns are the returns on a fund’s stock holdings and do not includeany fees or transaction costs. Net returns are the returns to a fund investor after fees and transaction costs. Index funds, sector funds and fundswith less than 10M in assets were excluded from the results. Measurements of Active Share reflect the mean value for the category.

Furthermore, the follow-up study reveals that the representation of closet index funds andtraditional index funds have risen to the point where they now represent approximately 40% ofthe active universe— making the exercise of differentiating them from true active managers moreimportant than ever.

Exhibit 1b: An increasing percentage of closet index funds muddies the results of truly activemanagers (1980-2009)

Source: “Active Share and Mutual Fund Performance,” by Antti Petajisto of the NYU Stern School of Business, September 2010.

”Average” active manager vs. true active manager

Studies suggest that passive investing has generally outperformed the average active manager, netof fees. This statistic includes both active managers who have underperformed due to a lack ofskill, as well as those who underperform net of fees because they are closet indexers. In additionto the work by Cremers and Petajisto cited earlier, other papers and studies, even those makingthe case for passive investing, reveal that good active managers can and have delivered betterreturns. William Sharpe, in his oft quoted 1991 article “The Arithmetic of Active Management,”3

which largely makes the case for passive investing, notes that: “It is perfectly possible for someactive managers to beat their passive brethren, even after costs . . . . It is also possible for aninvestor (such as a pension fund) to choose a set of active managers that, collectively, provides atotal return better than that of a passive alternative, even after costs. Not all the managers in theset have to beat their passive counterparts, only those managing a majority of the investor'sactively managed funds.”

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3 The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991

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Time horizons

Most investors would generally agree that one- and three-year periods are subject to market orshort-term performance noise. However, many might define “long term” as a period of five years.Yet as we consider the data series on active manager performance, we see a meaningful shiftfrom median manager underperformance in five-year periods to outperformance when extendedto 10 and 15 years. InterSec Research published the paper “The Benefits of Active Managementin Non-US Equities” in May 2009, which examined rolling time periods in an attempt tocompensate for the effect of survivorship bias embedded in the longer-term annualized numbers.Furthermore, InterSec found that “By lengthening the period of performance evaluation fromrolling one-year to rolling five- and 10-year periods, it becomes evident that the median activeEAFE Plus manager has consistently added value over the benchmark.”

An additional analysis of US Large-Cap Core managers measured the frequency of outperformance ofthe median manager using rolling time periods over 10 years (Exhibit 2). The results show thatthe median manager outperformed 100% of the time in the three-, five- and seven-year time periods.

Exhibit 2: Frequency of Outperformance by Median US Large-Cap Core Managers

Source: eVestment, gross of fees. As of June 2010

Two conclusions can be drawn here:

1) Active management accrues benefits as the time horizon is extended and through market cycles.

2) Shorter-term periods can be heavily influenced by other factors such as market conditions,making it difficult to evaluate an active manager’s skill.

Therefore, for investors who intend to allocate to a specific asset class for a relatively shortperiod of time, a passive approach is probably prudent. However, we believe longer periods oftime favor an active approach.

The Real Costs and Risks of Passive Investing

Index Volatility

There has been a rising popular acceptance of indexing as a “safer” or appropriate “default”strategy based on the misguided notion that it is less risky. For investors conditioned to thinkingin terms of relative performance, indexing will eliminate benchmark and manager risk. However,these investors are completely exposed to volatility, a measure of market risk that can have asignificant impact on absolute performance over time. For the many investors who actually focuson absolute performance or place greater value on a smoother ride, we believe passive investing

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offers little in the way of decreasing risk and could actually prove to be the riskier option. TheSharpe ratio, which is a measurement of return per unit of risk, provides an interesting metric toevaluate risk from volatility and its impact on index performance in absolute terms. Numerousanalyses have shown traditional market cap-weighted benchmarks have lower Sharpe ratios thanportfolios constructed on the active basis, as a result of higher volatility. “Variance drag,” defined as amathematical term in which a large decline must be followed by an even larger gain to make upthe loss, is a large part of the problem, particularly when compounded over longer periods of time.This is likely to be a greater risk in market cap-weighted indexes as they are inherently momentumdriven, allocating to stocks that have recently done well but may now be overvalued.4 Furthermore,in down years, more active managers tend to outperform indexes, which can eventually addgreater value than outperforming in an up year to due to the effects of compounding.5

Herd mentality and index distortion

For an investor, owning the index can actually have as much, or more, “risk” than taking activebets, particularly in extreme environments when indexes may become distorted. In the late 1990s,unprecedented valuations for tech stocks inflated their market caps and caused the technologyweighting in the Russell 1000 Growth Index to balloon to 44% after an extraordinary 80% risethat year. In 2000, an investor in a Russell 1000 Growth Index would have owned more than50% in Information Technology (IT) stocks, including almost a 5% position in Cisco6, whichhad appreciated 130% the prior year, only to endure the sector’s loss of over a third of its valuethat year (-35%) as the tech bubble burst. In contrast, an active manager had the opportunity tomake a valuation and diversification judgment, trim its technology holdings and re-invest theproceeds in many quality blue chip stocks trading at rarely seen valuations.

As Mark Twain is quoted, “History may not repeat itself, but it does rhyme.” And so it was thecase with Financials stocks in the Russell 1000 Value Index in the past few years. This time,valuations, market caps and weightings were not as inflated as the IT sector in the 1990s, however,going into 2007, Financials stocks had risen to over a third (36%) of the Russell 1000 ValueIndex just ahead of the first waves of the looming financial crisis. Investors in an index fund atthe beginning of 2007 would have suffered the Financials sector decline of 21%, followed by acrippling loss of over 50% in 2008. This investment would have also had over 3% invested infive Financials companies, each of which declined over 97% during 2008 as the crisis erupted.An active manager, who may have concluded from diligent analysis that some companies hadsignificantly more risk than others, had the opportunity avoid these names and underweight theFinancials sector generally.

Tracking error and fees

The issue of manager fees is a large part of the active vs. passive debate as investors question theobvious: why should I pay more for the same results? As we’ve discussed, we believe the resultsmay not actually be the same. Additionally, most studies are quick to factor in calculations of“average” management fees for active managers as well as tracking error as a measure of their“risk.” Yet the measures for passive investing are often left in a theoretical state, rather thanadjusted for the reality of implementation. In the transition from theory to implementation,passive investments pick up both tracking error and fees. Index funds are constructed to approximatean index but not replicate it, leading to tracking error. For large-cap developed markets, trackingerror and fees are generally very modest, but do impact the end result. However, the issues areeven more pronounced in less liquid segments of the market. In an extreme example, the EEM



4 Source: GSAM QIS, Is Indexing the Optimal Equity Strategy?, August 20105 Source: ISI6 Source: Cisco was the largest IT holding in the Russell 1000 Growth as of 12/31/00

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Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or itssecurities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securitiesdiscussed in this document.

(MSCI Emerging Markets Index Fund) ETF fees are 0.72% and the tracking error was greaterthan 6% in 2009 alone, which is comparable to, and in some cases greater, than that of an activemanager (Exhibit 3). Even assuming zero tracking error, index funds will inevitably underperformdue to the embedded fees compounded over time. Similarly, even if active managers perform in-line with the benchmark net of their fees, they still outperform passive managers. The chart belowillustrates the potential costs of fees and market risk associated with passive investments across avariety of equity investments.

Exhibit 3: Tracking error and expense ratios translate into real dollars at risk for passive investors

Expense Expense Tracking TrackingEquity bucket ETF Ratio (%) Ratio7 ($) Error8 (%) Error4 ($)New Growth Markets iShares MSCI Emerging Markets (EEM) 0.72 $11.4 M 3.24 +/- $45.7 M

Global iShares MSCI ACWI (ACWI) 0.35 $5.6 M 0.74 +/- $11.7 M

Europe SPDR EURO STOXX 50 (FEZ) 0.29 $4.7 M 0.53 +/- $8.4 M

US Mid-Cap SPDR S&P MidCap 400 (MDY) 0.25 $4.0 M 0.92 +/- $14.4 M

US Small-Cap Vanguard Small Cap ETF (VB) 0.14 $2.3 M 0.66 +/- $10.4 M

US Large-Cap S&P 500 SPDR ETF (SPY) 0.10 $1.6 M 0.78 +/- $12.3 M

Source: Bloomberg. Exchange Traded Funds are shown to demonstrate passive investing. These ETFs were selected because they constitute thelargest ETFs within each asset class. As of August 31, 2010.7 Based off a $100 million investment growing at 5% annually for 10 years.8 Tracking error is since inception for each ETF. Inception dates: EEM (4/11/03), ACWI (3/28/08), FEZ (10/15/02), MDY (5/4/95), VB (1/30/04), SPY(1/22/93).

Look ahead

Active managers use a forward-looking orientation in their stock analysis and investment processas they believe it gives them an important edge over backward-looking indexes, which favor stocksthat already have performed well. Active managers can evaluate their positions to “buy low” and“sell high,” while passive investors will always effectively buy more of the stocks and sectors thathave increased in price the most and will be increasingly underweight those that have performedthe worst. Momentum investors will essentially do the same. This works well in rising marketswith clear, easy-to-follow trends. However, when markets display less prominent trending,investors risk suffering sharp losses as mean reversion kicks in. Interestingly, we believe theincreased popularity of ETF investing, currently 30% of the daily trading volume (as of August2010), has created even greater inefficiencies for active managers to exploit going forward(Exhibit 4). As ETFs drive an increasingly larger percentage of equity trading volumes, stockprices are determined by non-company specific, technical factors and less by fundamentalfactors. This can lead to excellent entry and exit points for fundamentally-driven investors.

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Exhibit 4: Growth in ETF assets drive stocks to trade more on technical factors creating opportunitiesfor fundamental investors

Source: Bloomberg. As of August 2010.

Impact of Market EnvironmentsThe past several years have been characterized by periods of volatility extremes, driven bysentiment that became decidedly one-sided. Optimism in the persistence of global growth fueledthe low volatility bull market of 2003-2006, while fear drove the extremely volatile bear marketof late 2008. In each case, the dispersion of returns at the stock level was low, as investors treatedequities as an asset class rather than distinguishing between individual stocks.

However, going forward, we believe the stage is set for stock pickers as the markets have retractedfrom these extremes. Credit spreads have retreated to more normal levels, equity multiples arecloser to the long-term historic averages and volatility, as measured by the VIX, has come downsignificantly from its peak. As volatility declines over time, average stock correlations shoulddecrease (dispersion of returns should increase), and we believe stock prices should be driven bycompany-specific fundamentals (Exhibit 5).

Exhibit 5: Stock and sector correlations should decrease as volatility declines

a: Equity Market Volatility

Source: Goldman Sachs Global ECS Research, as of Sept 2010

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MSCI Average: 13.82SPX Average: 13.72

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b: Stock and sector correlations

We believe that the pattern of stock performance following the last downturn may be repeatingitself, as evidenced by the following charts. Exhibit 6a examines drivers of performance in thestrong bull market, from 2003 through 2007, that followed the burst of the technology bubble.During the initial period from 2003 to mid-2004, active managers struggled to beat indexes asthere was a simultaneous increase in corporate earnings and P/E multiples, with stock pricesrising faster than their earnings and little dispersion of returns at the stock level. After mid-2004,the environment improved for truly active investors as stocks traded more on fundamentals.

Exhibit 6b illustrates how the macro-driven, early stage recovery repeated in 2009. In theseenvironments, the impact of active management is limited as there is little differentiation inperformance between strong and weak companies or attractively valued and expensive ones.

Exhibit 6: Market cycles tend to repeat, and we believe that going forward stock prices will be

driven by fundamentals

a: 2003-2007

Source: Based upon S&P500. Furey Research Partners and FactSet.Mar 03

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This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions andshould not be construed as research or investment advice. Please see additional disclosures.

Dec 89 Dec 91 Dec 07Dec 93 Dec 95 Dec 97 Dec 99 Dec 01 Dec 03 Dec 05 Dec 09

Average sector correlation: .58

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Source: Based upon S&P500. Furey Research Partners and FactSet.

However, after that initial period of exuberance, we see a leveling off in earnings accompaniedby a contraction in P/E multiples. As earnings growth resumed in mid-2004, P/E multiplesremained relatively stable, indicating that share price performance, as approximated by the indexperformance, was more closely correlated with earnings growth. We believe we are at a verysimilar crossroads now, which creates an environment that should favor active managers whopick stocks based on their fundamentals.

We also believe that there will be a notable dispersion of returns on the horizon, especiallybetween higher- and lower-quality companies. Strong earnings growth and a high return onequity (ROE) are two metrics we use as a proxy for quality in companies. In an analysis of theperformance differential between the highest and lowest ROE stocks over the past two decades,we see that the higher ROE companies have outperformed, though they have gone throughnotable periods of underperformance along the way, including most recently.

Exhibit 7: High quality has outperformed over the long-term but not recently

Source: Based upon S&P500. Furey Research Partners, FactSet; As of 9/27/10.

When we look at companies with the highest earnings growth, over the past few decades, we seethat higher-quality companies are currently trading at a significant discount to their lower-qualitypeers (Exhibit 8). This presents an exciting investment opportunity as we believe high-quality stockswill outperform over the long term due to their distinctive competitive advantages, especially inthe slower growth environment expected ahead.

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This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions andshould not be construed as research or investment advice. Please see additional disclosures.

Mar 09

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Exhibit 8: Quality businesses are trading at attractive valuations vs. low-quality counterpartsS&P 500: Average Forward P/E by Long-Term Growth Estimate Quintile6

6 Source: MorganStanley. For illustrative purposes only. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. Please see additional disclosures.

Greater value of active management during periods of lower returns

We believe the value of active management is more pronounced in a lower-return environment—consistent with what we expect ahead. Using simple math, an excess return of 2.0% wouldincrease a portfolio’s performance by 50% if the market returned only 4%, but is less impactfulon a 25% market return (8% of total return). Equally important, active managers tend to outperformin a greater order of magnitude in negative, or lower-return environments (Exhibit 9a). This overallability to preserve more capital in down markets provides a meaningful tailwind when the marketsturn, helping to mitigate the effect of variance drag or, in other words, negative compounding.

Exhibit 9a: Active managers tend to outperform when the markets are down or in a trading rangeAverage Monthly Gross Excess Returns Analysis of the Large-Cap Core Universe (6/30/1980 – 6/30/2010)

Source: eVestment.

-6.82% -7.48%

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0.5% 0.4% 0.1%

Trading Range MonthsBenchmark: -4% to 4%

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(87 months)

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Valuation Convergence

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Exhibit 9b: We believe active managers outperform the index over time

Source: eVestment and GSAM. Gross returns.

Conclusion While we believe investors can benefit from both active and passive investments in a portfolio,we encourage investors to critically examine studies that too easily favor passive investing. Activemanagement is not homogenous; it comes in many forms and with managers of varying skill, allof which can muddy analyses of “active” managers. Short- and medium-term market conditionscan also meaningfully influence performance results that are not reflective of longer-term trends.Additionally, investors must be mindful of real costs and risks, not just theoretical and relativeones, when assessing active versus passive investments. We believe successful investment approachesmust be forward-looking to capture mispriced value, as markets themselves anticipate change.Historical ranges and statistical relationships can be distorted or break down completely in anuncertain or changing environment. Therefore, investors must endeavor to be forward-looking,despite the comfort and temptation of using historical data as a roadmap. Experienced investorswill focus their approaches where they believe they have an edge to take risk and make high-conviction investments. While market conditions such as volatility, correlations, and momentumtrends have played a large role in equity performance over the past several years, the environmentis in transition, and successful managers will now need to take an active approach to investing asstock fundamentals will likely drive returns.

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This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.

Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can godown as well as up. Future returns are not guaranteed, and a loss of principal may occur.

Indices are unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenseswhich would reduce returns. Investors cannot invest directly in indices.

This material has been prepared by GSAM and is not a product of the Goldman Sachs Global Investment Research (GIR) Department except wherenoted. The views and opinions expressed may differ from those of the GIR Department or other departments or divisions of Goldman Sachs and itsaffiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be currentand GSAM has no obligation to provide any updates or changes.

Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness.We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without GSAM’s prior writtenconsent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer,director, or authorized agent of the recipient.

Copyright © 2010 Goldman, Sachs & Co. All Rights Reserved. (43462.OTHER.SA) PS-FEC/11-10

Economy & Finance

Rethinking the debate activepassive