The Active vs. Passive Investment Debate Discussion on: The Rewards and Risks of Active vs. Passive...

The Active vs. Passive Investment DebateDiscussion 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 StrategyNorth American Value Added Experience

Asset Mix Timing Security Selection

Ave

rage

An

nu

al V

alu

e A

dd

ed

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 BeRight At Least 2/3 of the Time*

A. Bull markets last longer than Bear marketsB. Stocks go up more over time than go downC. 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


Weak FormA security’s price reflects all the information contained in the historic price record. Past prices cannot provide informationof any value in helping to determine future prices.

Semi Strong FormAt any given time, all relevant public information is fully reflected in the security’s price.

Strong FormAll public and private information is fully reflected in the security’s price

10


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


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, March 1988. In “Events That Shook The Market”, Roy C. Fair found that “many large stock price changes have no events associated with them” , Page 713, 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

Exc

ess

Ret

urn

(%)

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 0.760.48

0.960.75 0.63

0.880.59 0.57

0.820.60 0.72

0.32 0.38 0.38 0.310.63

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

Sp

read

(%

)

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

Exc

ess

Ret

urn

(%

)

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 - TSXMean (1990-1998) = 4.9

3rd Quartile - TSX:Mean (1990-1998) = -1.5





Source: eVestment Alliance

23

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Exc

ess

Ret

urn

(%

)

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 CapMedian –

S&P/TSX Small Cap3rd 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


24

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Exc

ess

Ret

urn

(%)

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 500Median – 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 500Mean (1990-1997) = 4.4

3rd Quartile – S&P 500:Mean (1990-1997) = -2.8






25

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Exc

ess

Ret

urn

(%)

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 – R2000Mean (1990-1998) = 11.1

3rd Quartile – R2000:Mean (1990-1998) = -2.0






26

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Exc

ess

Ret

urn

(%)

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 500Mean (2002 - 2007) = 5.1

3rd Quartile – S&P 500:Mean (2002 - 2007) = -1.9


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 mustunder-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. 7-9Copyright, 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

0Assets Under Management

Beat the Market

Lose to the

Market

32

Do We Really Understand Execution?

Commission5¢ (17bp)

Impact10 ¢ (34 bp)

Delay23 ¢ (77 bp)

Missed Trades9 ¢ (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 EconomistMarch 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.

Con

trib

uti

on t

o E

xces

s R

etu

rn/R

isk

Correlation

Short Selling

Portable AlphaMarket Neutral

T-Bills Long-BondsCdn. EquitiesWorld Equities

37

Exp

ecte

d R

etu

rn

Risk

< 10%

< 18%

< 5%LongBonds

T-Bills

60/40

LongShort

< 7% < 11% < 16%

The Spectrum of Active Management Strategies

Portable Alpha &MarketNeutral

Equities

Small Cap

130/30Cdn.

EquityPlus

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 MNEquity Index

Cdn. 91Day

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

CSFBMN Equity

Index0.06 -0.06 0.03 0.03 1.00

Cdn. 91 DayT-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

The Active vs. Passive Investment Debate Discussion on: The Rewards and Risks of Active vs. Passive...

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