Are Active Managers Doing Their Job?

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1 Are Active Managers Doing Their Job? A White Paper by Manning & Napier Unless otherwise noted, all figures are based in USD. 1

2 Introduction Since the market downturn of 2008, active equity managers have come under fire. Not only did many of these managers fail to provide meaningful downside risk management relative to market indices during the credit crisis, but most have failed to keep up with their benchmarks as the markets subsequently rallied. Not surprisingly, this time period has seen resurgence in the mantra that active managers can t justify their fees and investors should instead choose passive index products. In fact, since November of 2007 (the approximate start of the last market downturn), investors have done just that and poured over $350 billion into passive equity mutual funds, while withdrawing approximately $300 billion from active equity mutual funds. Additionally, another $800 billion flowed into equity exchange traded funds, which mostly implement passive strategies. It certainly appears that many equity investors have decided that passive strategies represent the most attractive means of gaining exposure to the equity markets. Likewise, that decision has seemingly been proven correct from a purely return-oriented perspective over the past five to seven years. However, while maximizing returns may seem like an attractive goal on the surface, we believe that an investment portfolio should primarily be managed to meet an investor s specific long-term objectives. Thus, effective risk management becomes just as important as generating attractive returns (if not more so). As such, we believe that investors should seek to achieve returns that reasonably compensate them for the risks being taken in their portfolio rather than try to squeeze every last penny out of returns while effectively ignoring the risks. With this in mind, we would like to explore several topics which will hopefully provide investors with useful context when making decisions regarding active versus passive management. What are the potential risks of equity investing? Do market indices effectively manage these risks for investors? Are active managers in a better position to provide effective risk management? What factors may affect the performance of active managers relative to market indices? How have these factors contributed to the recent underperformance of active managers? Potential Risks and Rewards of Equity Investing In general, most investors buy equities to achieve attractive long-term returns or, at the very least, higher returns than could be achieved by investing in bonds and holding cash. Additionally, most investors likely recognize that one of the main risks of investing in equities is the possibility of losing a significant portion of the original investment. Thus, under ideal circumstances, a successful investment in equities is designed to achieve attractive long-term returns, while seeking to limit sustained and significant loss of capital. Clearly there are no guarantees that permanent losses of capital (i.e., losing a portion of the original investment) can be completely avoided when investing in equities. However, we believe that the best means of managing the risk of permanent capital losses is to avoid overpaying for stocks. Intuitively, most investors would probably agree that paying $50 for a stock that is only worth $20 is unlikely to make money over the long term. In fact, as investors discovered during the technology bubble of the late 1990s, overpaying for stocks is probably one of surest ways to lose money in the equity markets. For example, investors who bought Cisco Systems in March of 2000 for $80 per share were forced to realize rather quickly that they probably overpaid for the stock, as it declined to approximately $16 per share by the same time the following year. While the true value of Cisco at that time may have been higher than $16, it was likely quite a bit lower than $80. Thus, investors who purchased the stock for $80 would likely have little hope of ever recovering the value of their original investment short of another massive price bubble. Chart 1: Cisco Systems Inc. Closing Price $90 $80 $70 $60 $50 $40 $30 $20 $10 $0 2/20/1990 7/31/1991 1/8/1993 6/20/ /28/1995 5/8/ /19/1998 3/31/2000 9/18/2001 3/3/2003 8/12/2004 1/24/2006 7/9/ /16/2008 6/1/ /8/2011 4/2/2013 8/26/2014 2

3 Risk Management and the Deficiency of Market Indices Most major equity indices were originally designed to represent the broad performance of the markets they seek to track (e.g., the S&P seeks to broadly track the performance of U.S. large cap stocks). As such, the goal of these indices is not to provide a universe of companies with the most attractive investment prospects, but simply to present a relatively accurate picture of the current investible universe of stocks. Under this construction methodology, the biggest companies are generally the ones with the biggest weight in the index (i.e., most indices are market cap weighted) and some indices are specifically designed to simply include the 500 or 1,000 largest companies in their specific market. Since an index makes no explicit assessment of the investment merits of its constituent companies or their actual value, it generally provides investors with very little protection from overpaying for the stocks they buy. Even though the top holdings in the index could be extremely well run companies, they may not necessarily represent attractive investments. While the companies with the largest weight in the index were likely very successful (or very overvalued) at some point during their history in order to achieve such a scale, an investor buying the index s current holdings isn t investing in the company s past history but rather its future prospects. It is conceivable that the top holdings in the index could be valued based on their impressive record of historical growth when their actual future growth prospects are more mediocre, or their future growth prospects could already be fully reflected in the price. In fact, it can be argued that the market cap weighted nature of most indices actually helps contribute to the very price bubbles observed in Cisco and other technology companies in the late 1990s, as continuing outperformance in the index s largest holdings makes them an ever increasing percentage of the index. This creates a potentially dangerous feedback loop. For example, in March of 2000 (as the price of Cisco peaked) it was the second largest holding in the S&P at just over 4%. The index s potential to be concentrated in overvalued stocks can be further extended to a sector level, as technology holdings came to represent over 30% of the S&P just prior to their sharp correction. Likewise, financial stocks represented approximately 22% of the S&P at the beginning of 2007 (i.e., just prior to the credit crisis) before declining meaningfully in 2008 and accounting for only 10% of the index by the beginning of Chart 2: S&P Weightings 40% 35% 30% 25% 20% 15% 10% 5% 0% 9/30/1989 5/31/1991 1/31/1993 9/30/1994 5/31/1996 1/31/1998 9/30/1999 5/31/2001 S&P Financials Weighting S&P Technology Weighting Lastly, while the majority of this discussion has concerned the equity markets, fixed income benchmarks present many of the same risk management challenges for investors as their equity counterparts. Most notably, the sector and security allocations of most fixed income benchmarks are determined simply by the amount of bonds currently being issued in that sector, or the size of the specific security in question. Thus, if more Treasury securities are currently being issued than corporate bonds, Treasuries will gradually become an ever increasing portion of fixed indices while the weight of corporate bonds would decline. Over the past several years, this is precisely what has occurred in most broad fixed income indices, as the weight to U.S. Treasury securities in the Barclays Capital U.S. Aggregate Bond Index* increased from approximately 20% at the beginning of 2010 to approximately 35% by December of With yields on Treasury securities remaining near historic lows, it can be argued that their current valuations are far from attractive. However, for index investors, Treasuries would represent their single largest fixed income holding. 1/31/2003 9/30/2004 5/31/2006 1/31/2008 9/30/2009 5/31/2011 1/31/2013 9/30/2014 3

4 Understanding Active Management and the Impact of Valuation In stark contrast to the mechanical rules used for index construction, many active managers are specifically looking for undervalued or mispriced securities. Thus, avoiding overpaying for the stocks they purchase is a key risk management tool for active managers. As such, if the largest holding in the index is trading at $50 but is actually only worth $20, it is less likely that a valuation conscious active manager would purchase the stock. However, the holding would remain in the index simply by virtue of its size. While the above statement generally applies to most nonindex equity mutual funds, we believe that managers can only truly be active if their holdings differ meaningfully from the benchmark. Intuitively, if a manager s investments are governed by what stocks are included in major market indices, then the likelihood of that manager avoiding overvalued stocks may be greatly reduced given the construction methodology of most indices. Thus, when discussing active managers, the analysis to follow will be referring specifically to those managers that differ substantially from the index from a holdings perspective. Specifically, the analysis will utilize the concept of Active Share. Active Share measures the difference between an investment manager s portfolio and an index on a holdings basis. Differences may arise from managers not holding securities included in the index, holding securities other than those included in the index, or holding securities in different weights than are found in the index. A portfolio s Active Share will range between 0% and 100%, with 0% signifying that the portfolio is identical to the index, and 100% signifying that the portfolio and the index have no common holdings. We believe the Active Share calculation provides a more systematic way of evaluating the extent to which a manager is differentiating itself from an index, and can help to identify closet indexers (active managers with index-like portfolios). Thus, for the purposes of this analysis, active managers will be defined as those that exhibit top quartile Active Share (i.e., approximately 89% and above). Since managers in this group have portfolios that carry very little overlap with the index, their purchase and sale decisions are more likely to be influenced by valuation and the manager s pricing disciplines. Performance during Equity Bear Markets The effects of pricing disciplines were highly evident as the tech bubble burst in early 2000s and many active managers meaningfully outperformed their respective benchmarks. In fact, in the aftermath of the 2000 bear market, valuation oriented active managers gained notoriety for their ability to manage risk during market downturns. In contrast to today s environment, all active equity managers (not only those with high Active Share) saw very strong flows on the basis of their impressive returns from 2000 to 2002 ($650 billion in flows for active equity managers versus $180 billion for passive strategies). However, as the table below illustrates, the 2008 market downturn was much less kind to active managers, as many participated meaningfully in the market s decline. As such, it is reasonable for investors to ask how 2008 differed from the early 2000s and what return pattern they should expect from active managers. Time Period Tech Bubble Bursts (04/ /2002) Credit Crisis (11/ /2009) Returns of Active Managers 2 Returns for periods greater than one year are annualized. S&P Returns % % % % As mentioned previously, most active equity managers are looking for attractively priced securities. This is not merely a defensive tactic to avoid overpaying for stocks, but is also designed to generate attractive long-term returns. Assuming the value of a stock stays relatively stable, and the stock s price eventually converges to its true value, purchasing that stock at a larger discount to its actual value would generally lead to higher returns. Broadly speaking, active managers have the opportunity for strongest relative performance during periods where many stocks are meaningfully mispriced (i.e., either by avoiding highly overvalued stocks or buying those deemed highly undervalued). However, whether this focus on mispricing results in downside risk management during bear markets very much depends on the specific nature of the bear market. 4

5 For example, the bear market of the early 2000s was, all things considered, relatively narrow. Specifically, the biggest losses were relegated primarily to the technology and telecom stocks, which reached astronomical valuations in the late 1990s. While the broad equity markets did correct meaningfully during 2002, the most overvalued portions of the market generally suffered the biggest losses over the entire period. Time Period S&P Technology S&P Return Sector Return Tech Bubble Bursts (04/ /2002) % % Returns for periods greater than one year are annualized. In this type of environment, many price conscious managers were able to outperform broad market indices by virtue of what they didn t hold, namely overpriced technology stocks. In fact, the price conscious managers also avoided those stocks during their impressive run-up in the late 1990s and trailed the index meaningfully before eventually being validated as the bubble burst. Thus, in a bear market driven by a valuation correction in a specific market segment, a strong valuation discipline may indeed be defensive. However, while excessive valuation in certain market segments often occurs prior to bear markets, other bear markets are much more macro driven. Specifically, the main cause of the downturn is a widespread economic decline or credit contraction which results in broad based fear in the equity markets and leads to fairly indiscriminate selling of equities. This type of market downturn is precisely what happened in While it can be argued that certain segments of the equity markets were overvalued, or at least facing severe fundamental risks, the main price bubble turned out to be in the housing market and, more broadly, the credit markets. The resulting downturn not only affected the specific industries involved, but caused widespread fears about the solvency of the entire global financial system. In this environment, the equity markets (and most risky assets) sold off sharply across the board with very little differentiation between various equity market segments or specific stocks. For example, as the following chart illustrates, while only 5 of the 10 major equity sectors suffered double digit declines during the 2000 market downturn, every single sector suffered declines of -20% or greater during the 2008 downturn. Thus, just because a certain company was more attractively valued, that did not mean its price held up better during the downturn. In fact, as the paragraphs below explain, it may have actually fared worse. S&P Sector 3 Tech Bubble Bursts (04/ /2002) Credit Crisis (11/ /2009) Consumer Discretionary Consumer Staples Energy Financials Health Care Information Technology Industrials Materials Telecom Services Utilities Returns for periods greater than one year are annualized. Valuation vs. Volatility In today s markets information about most companies is relatively easy to obtain. As such, companies that are trading at lower multiples (i.e., those could be considered undervalued) are usually undervalued for a reason. The reasons could include near-term company specific difficulties, notable headwinds to the company s industry, or the company having large exposure to certain macro factors (e.g., war). If an active manager decides that such a company may represent an attractive investment, it is likely that they have a different opinion from the market about the company s long-term prospects (otherwise they would simply accept the market price as the company s true value). However, for the value in that specific company to be realized, the market has to eventually come around to the active manager s opinion. This process could take days, months, or even years. Assuming the market s opinion of the company has not changed and a macro driven bear market occurs (e.g., as in 2008), that company would still be perceived as being inferior to its peers and may actually decline more during the downturn (irrespective of its eventual improved prospects). Thus, an active manager 5

6 holding these kinds of companies through a downturn like 2008 should not necessarily be expected to outperform the broad index, and may actually underperform. That being said, if the manager s assessment of the company proves correct and its prospects indeed improve after surviving the downturn, the potential appreciation in its stock price could be meaningful as the price could revert and then surpass its previous high as the market comes around to the manager s position. Likewise, in the aftermath of bear markets, where investors indiscriminately sell equities, there could be substantially more opportunities to acquire good companies at attractive valuations (whereas previously those companies may have been deemed too expensive), which could improve returns during the subsequent recovery. For example, as Chart 3 illustrates, in the midst of the 2008 bear market, the price of Google declined from a high of approximately $360 in December of 2007 to a low of approximately $130 in November of While Google s business fundamentals generally remained strong, investors fleeing equities sold healthy companies along with those more adversely impacted by the financial crisis. In fact, Google shares actually underperformed the broad market in 2008, declining approximately -55% compared -37% for the S&P However, as the crisis receded and investors once again placed a greater focus on company fundamentals, Google s shares returned approximately 102% in 2009 and its price increased to over $600 per share by the beginning of Chart 3: Google Inc. Class A Closing Price $700 $600 $500 $400 $300 $200 $100 $0 01/28/05 01/28/06 01/28/07 01/28/08 01/28/09 01/28/10 01/28/11 01/28/12 01/28/13 01/28/14 Thus, if a manager s assessment of a company s true value is fairly accurate and its price increases accordingly, the decline in the company s price in the interim is, by definition, temporary. An investor s ultimate profit or loss when buying a stock is the difference between the price when the stock was bought and the price at which it was sold (plus any dividends received in the meantime). Any fluctuations in the price that happen while the stock is held (but not sold) represent volatility and not a permanent loss of capital. In contrast, an investor who purchases a stock at significantly above its fair value has a much higher probability of suffering a permanent loss of capital, since the stock s price would have little reason to approach, much less surpass, its previous highs. It is, however, important to note that volatility could become a permanent loss of capital if a stock is sold when its value is temporarily depressed. Most often, an investor s immediate need to raise cash (to meet spending needs) may result in such sales; however, emotion and investor behavior can also play a large role. Most notably, since equities are inherently volatile, equity investing requires patience and a long-term time horizon. As the next section illustrates, we believe that patience and a truly long-term perspective are also central to accurately evaluating the performance of active mangers. The Need for Patience Thus far we have established that investing in a market index may not be the best method of avoiding overpaying for stocks. Likewise, we have argued that active equity managers are likely to benefit the most when meaningful mispricing of securities occurs. Lastly, we have illustrated that while active managers may provide downside risk management during certain bear markets, they may perform more in line with indices during others. The one factor that has been missing for this discussion is the issue of timing, or more specifically, how often can meaningful mispricing of securities happen, and how long can it usually take for this mispricing to correct? As with many complex questions, the answer to the questions presented above is, it depends. Truly meaningful mispricing across large sections of the equity markets doesn t happen very often and has historically only occurred after major market dislocations (e.g., bear markets) or due to ingrained beliefs shared by the majority of the investment community. Source: FactSet 6

7 For example, in the 1940s, many investors were avoiding equities as they expected another depression in the aftermath of World War II (as had occurred after the Civil War and World War I). As such, a large number of stocks were trading at very attractive valuations (the markets subsequently went on to achieve very impressive returns when a depression did not occur). Likewise, 1962 marked the end of one of the first bubbles for electronic stocks, as valuations became elevated before the markets eventually declined by over -20%. Lastly, the bear market of 2008 was associated with a broad macro downturn which severely shook investor confidence in the return potential of stocks. On a somewhat smaller scale, the market downturns of 1990 (in the aftermath of the savings and loan crisis) and 1998 (associated with currency turmoil across emerging markets) were additional examples of notable macro-driven market declines. However, active managers can t simply wait for a once in a decade event to shop for bargains and have to find attractive investment opportunities across all kinds of market environments. Luckily, mispricing in specific market segments and/or individual stocks has historically occurred with greater frequency than market-wide mispricing. That being said, this type of mispricing still doesn t occur every day or every month, and may require considerable time and effort to discover. Furthermore, when mispricing in certain securities is discovered, it may take a long time to correct. The events that lead to a stock achieving full value may take months or even years to unfold. As such, a holding period of several years for certain stocks should be expected for many active managers. Additionally, just as market wide valuation dislocations may happen fairly suddenly, the valuation of a specific company may not adjust gradually over time but instead increase (and in the interim, even decrease) in spurts. Thus, while it may take five years for a stock to reach full value, the majority of that value could well be realized in the last two months of the fifth year. In this context, when evaluating the performance of active managers, we believe that investors should keep in mind several important points: While good active managers should be able to outperform over the long term, they most likely will not outperform on a consistent basis (i.e., year-to-year or quarter-to-quarter). Substantial outperformance could occur over a relatively short time period. There can be meaningful periods of time (i.e., five years of longer) where active managers with attractive longterm track records may underperform their respective benchmarks. Active managers are more likely to trail their respective benchmarks during periods when security mispricing isn t widespread or when valuations are speculative. Utilizing the universe of truly active managers defined previously, Charts 4 and 5 clearly highlight the concepts outlined in the bullet points. Chart 4: Growth of $1 $3.00 $2.50 $2.00 $1.50 $1.00 $0.50 $0.00 Active U.S. Equity Managers 2 Chart 5: Rolling 3-Year Return 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% 3/1/ /1/1989 3/1/ /1/1991 3/1/2002 3/1/ /1/1993 3/1/ /1/1995 3/1/ /1/1997 3/1/ /1/1999 3/1/ /1/2001 3/1/ /1/2003 3/1/2009 3/1/ /1/2005 3/1/2011 3/1/2012 3/1/2013 S&P /1/ /1/ /1/2011 Active U.S. Equity Managers 2 S&P /1/ /1/2013 7

8 Specifically, the charts illustrate that: Since 04/01/2000, a time period which includes a wide variety of market environments (including bear markets, recoveries, and bull markets), active managers have added substantial value over the index. However, as Chart 5 illustrates, relative performance over shorter time periods has exhibited considerable volatility. Lastly, the relative returns of active managers around the late 1990s and early 2000s clearly illustrate how periods of meaningful underperformance can reverse fairly rapidly as market conditions change. The Current Market Environment Evaluating performance of active equity managers versus market indices since the start of the current bull market (03/01/2009) or even the start of the last market downturn (11/01/2007) leads to a relatively unfavorable conclusion for active managers. As the table below illustrates, active managers performed generally in line with the index during the market downturn and have trailed the index over the current bull market. Credit Crisis (11/07 2/09) Bull Market (3/09 12/14) Returns of Active % 20.42% Managers 2 S&P % 21.87% Returns for periods greater than one year are annualized. While on the surface these returns appear to support the move by investors away from active management, our discussion thus far has illustrated that good active managers may, in fact, perform in-line or trail market indices for prolonged periods of time. Thus, while more recent returns of active managers don t look attractive relative to the index, we have already demonstrated in Chart 4 that truly active managers have exhibited a meaningful performance advantage versus the index over longer-term time periods. Likewise, we have also highlighted the importance of evaluating active manager performance in the context of various market environments, specifically as it relates to valuation and the prevalence of security mispricing. As such, the following table shows the performance of active managers and the S&P over the period from 04/01/2000 to 12/31/2014, as well as over several distinct market environments that have occurred over the time period (i.e., market declines, recoveries, and bull markets). Market Cycle (04/00 12/14) Tech Bubble Decline (04/00 09/02) Failed Recovery (10/02 10/07) Credit Crisis (11/07 02/09) Current Bull Market (03/09-12/14) Returns for periods greater than one year are annualized. S&P Returns of Active Managers 2 Returns 7.24% 4.15% % % 17.26% 15.54% % % 20.42% 21.87% The table clearly illustrates that active managers have added considerable value over the entire time period and have outperformed the index over every type of market environment except the current bull market. The logical question raised by this table is, what specific factors about the current environment have led to the observed performance pattern? The 2008 Market Decline Before discussing returns over the current bull market, let us first examine active management returns leading up to and during the credit crisis. First, we have already illustrated that the market downturn in the early 2000s was generally favorable for active managers, as the prevalence of security mispricing leading up to the downturn was relatively high. From a valuation standpoint, the price to earnings (P/E) ratio of the S&P declined meaningfully from its peak of 26 times earnings at the end of 1999 to 15 times earnings by September of It can be argued that prior to the downturn, large parts of the equity markets were mispriced (i.e., overvalued). As discussed previously, many price conscious managers were unwilling to overpay for stocks in this environment and, as a result, provided attractive downside risk management when the tech bubble burst. In the aftermath of the 2000 bear market, the S&P increased by nearly 110% cumulative (although the index only slightly surpassed its previous peak just prior to the credit crisis, on a price basis). However, as Chart 6 on the following page illustrates, the P/E ratio of the index actually decreased over the time period. Thus, just prior to the 8

9 credit crisis, the U.S. equity markets as a whole traded at valuations that were fairly reasonable from a long-term perspective. Since the level of equity mispricing prior to the 2008 market downturn was significantly smaller than the 2000 market downturn, the opportunity to provide meaningful downside risk management for active managers was generally reduced. Chart 6: S&P P/E vs. Total Return /01/02 10/01/03 Source: FactSet. 10/01/04 10/01/05 10/01/06 10/01/07 10/01/08 10/01/09 10/01/10 10/01/11 S&P P/E - NTM (left axis) S&P Total Return (right axis) 10/01/12 10/01/13 10/01/14 4,000 3,500 3,000 2,500 2,000 1,500 1, While correlations and valuation dispersion can be influenced by a variety of factors, bond purchases by the Federal Reserve (discussed in more detail on the following page) have reduced interest rates to near historic lows and may have driven investors to simply gravitate towards equities as an asset class rather than evaluating the merits of individual stocks/sectors. In this type of environment, stocks have tended to move up or down together with smaller differences between the price movements of individual securities. Likewise, the smaller valuation dispersion has likely resulted in less opportunities for active managers to take advantage of security mispricing. Chart 7: Rolling 13-Week Average Correlation of U.S. Stocks vs. the S&P 500 1, % 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% The Current Bull Market Moving on to the current bull market, the underperformance of active managers may be somewhat less intuitive. Most notably, Chart 6 doesn t appear to suggest that equity valuations are approaching speculative levels (i.e., 25 or 30 times earnings) as they did during the late 1990s. However, there are several factors in the current environment that we believe can provide important context for evaluating the underperformance of active managers. Increased correlations among individual stocks has resulted in less differentiation among companies based on fundamentals, as well as valuation compression. First, as Charts 7 and 8 illustrate, the median correlation of individual stock returns versus the return of the S&P has been consistently elevated since approximately Additionally, the valuation difference (measured by the price to earnings ratio) between the highest and lowest valued S&P sectors has also remained relatively low compared to history. Chart 8: P/E Dispersion Among S&P Sectors % April-02 4/2/1988 April-03 4/2/1990 April-04 4/2/1992 April-05 4/2/1994 April-06 4/2/1996 4/2/1998 April-07 4/2/2000 April-08 4/2/2002 April-09 4/2/2004 April-10 4/2/2006 April-11 4/2/2008 April-12 4/2/2010 April-13 4/2/2012 4/2/2014 April-14 9

10 Easy central bank monetary policy has resulted in interest rates remaining near historic lows since the end of the credit crisis, encouraging investment in riskier assets. The asset allocation decision is generally considered one of most important factors in determining an investor s longterm returns. At the most basic level, asset allocation can be distilled into the decision of allocating assets between stock and bonds. All else being equal, stocks have historically provided attractive capital appreciation over the long term while high quality bonds have been a source of return stability during equity market downturns. Likewise, valuations have historically proven to be an important factor in determining future returns of stocks (i.e., future equity returns have generally been higher when starting valuations were low), while current yield levels have been the most significant factor in determining future bonds returns (i.e., future bonds returns have generally been higher when starting yields were high). As we have seen from the chart on the previous pages, although current valuations don t necessarily suggest that equities are attractively valued, Chart 9 does show that current yields on high quality bonds are at the their lowest levels since the 1950s. In general, future bonds returns at these starting yield levels (i.e., just over 2%) have historically been approximately 3-4% (for U.S. Intermediate Term Government Bonds) 5. Chart 9: 10-Year U.S. Treasury Yield Source: FactSet Thus an investment in bonds at current yield levels appears unlikely to generate returns observed in the asset class over the past 30 years (where yields reached double digits at certain points in time), or even their long-term average (i.e., approximately 5% for U.S. Intermediate-term government bonds since 1926). Likewise, future bonds returns may even have difficulty overcoming inflation, which has historically averaged approximately 3%. Given these potentially muted return prospects for bonds and the liquidity injected into the financial market by the Federal Reserve through bond purchases, the equity asset class as a whole may appear much more attractive to investors on a relative basis, despite current valuation levels. As such, the low level of interest rates could potentially lead investors to simply invest in equities more broadly, given the lack of attractive fixed income alternatives, and focus less on investing in attractively valued stocks. Likewise, in the current low interest rate environment, valuation may be superseded by the search for yield as investors gravitate toward higher dividend yielding stocks. Just as importantly, low interest rates could potentially give investors a false impression about the profitability of certain companies, since it costs relatively little to borrow money in the current environment and profitability may be increased simply through the use of leverage. The record flows to equity index funds could be distorting the market s price discovery mechanisms. In general, given the recent underperformance of active managers in the current bull market and their failure to meaningfully outperform during the previous market downturn, investors recent preference for passive index funds is somewhat understandable. That being said, as previously discussed, stocks are included in market indices based on mechanical rules and not their investment merits. Thus, by investing in equities using index funds, investors are not expressing any opinion about the attractiveness of the securities they are buying or selling. It is important to note that the major theoretical basis for the existence of index funds is the efficient market hypothesis. At the most basic level, the hypothesis states that current market prices reflect all available information about each security and, as such, conducting further analysis is of limited value. Ultimately, the hypothesis assumes that the sheer number of investors conducting daily research on individual securities will quickly discover any relevant information about a given stock and correct security mispricing almost instantaneously. Thus, investors should simply put their money into index funds and not bother with fundamental research. 10

11 However, if every investor did indeed simply place their money into index funds and stopped conducting individual security research altogether (i.e., to discover undervalued securities), then the very price discovery mechanisms which support the efficient market hypothesis would theoretically break down. Likewise, in the short term, the mispricing in individual securities favored by active managers wouldn t necessarily correct, since index investors are not making decisions based on valuation. While it is difficult to predict if the trend toward indexing will continue, the premise that investors will continue to ignore valuation and company fundamentals forever is difficult to accept. It is conceivable that, at some point, a greater focus on valuation will once again become more prevalent in the investment community. If this does indeed occur, the environment could potentially become more favorable for active managers. Conclusion We believe that patience is key when investing with active managers, as even the best managers are not likely to outperform consistently and may experience prolonged periods of time when relative performance is challenged. However, during periods where security mispricing is more prevalent, active managers may have the opportunity to meaningfully outperform. That being said, in order to have the opportunity to take advantage of security mispricing when it occurs, we believe a manager needs to have the perspective and flexibility to look very different from the benchmark. However, if an investor is judging risk solely by short-term performance variations relative to an index, this type of manager is almost guaranteed to have periods where they fail in that respect. In fact, if limiting performance deviation versus the index is an investor s ultimate goal, then passive management is the strategy that likely best meets that goal. However, if an investor believes that the price you pay for investments is an important influence on future returns, then we believe active management has attractive long-term merits. Analysis by Manning & Napier. Source: Morningstar All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results. All data are subject to revision. Manning & Napier Advisors, LLC is governed under the regulations of the United States Securities & Exchange Commission (SEC). *Data based on the SPDR Barclays Aggregate Bond ETF (LAG). The Barclays U.S. Aggregate Bond Index is an unmanaged, market-value weighted index of U.S. domestic investment-grade debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of one year or more. Index returns do not reflect any fees or expenses. 1 The S&P 500 Total Return Index is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. Index returns provided by Morningstar. S&P Dow Jones Indices LLC, a subsidiary of the McGraw Hill Financial, Inc., is the publisher of various index based data products and services and has licensed certain of its products and services for use by Manning & Napier. All such content Copyright 2014 by S&P Dow Jones Indices LLC and/or its affiliates. All rights reserved. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and none of these parties shall have any liability for any errors, omissions, or interruptions of any index or the data included therein. 2 Universe includes all U.S. domiciled open end mutual funds with a Morningstar Institutional Category of All-Cap Core, Giant Core, Large Core, Large Valuation-Sensitive Growth, or Large Relative Value. The oldest available share class of each fund was used. 3 Investments will change over time. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property and a service mark of MSCI Inc. (MSCI) and Standard & Poor s, a division of The McGraw-Hill Companies, Inc. (S&P), and is licensed for use by Manning & Napier when referencing GICS sectors. Neither MSCI, S&P, nor any third party involved in making or compiling the GICS or any GICS classifications makes any express or implied warranties or representations with respect to such standard or classification, nor shall any such party have any liability therefrom. 4 Includes all stocks listed on the NYSE or NASDAQ exchanges with a business country of United States and a market cap of $5 billion or greater. Includes universe of stocks which were listed at each point in time. 5 U.S. Intermediate Government Bond data is reflective of the Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index, which is an unmanaged index representing the U.S. intermediate-term government bond market. The index is constructed as a one bond portfolio consisting of the shortest-term non-callable government bond with no less than 5 years to maturity. The Index returns do not reflect any fees or expenses. Index returns provided by Morningstar. Approved CAG-PUB001-R USCDN (3/15) 11

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