BY DAVID B. MAZZA, HEAD OF ETF INVESTMENT STRATEGY, AMERICAS, AND THOMAS F. GUARINI, PRODUCT SPECIALIST, STATE STREET GLOBAL ADVISORS

Transcription

1 Leveraging the Best of Active and Passive Investment Approaches BY DAVID B. MAZZA, HEAD OF ETF INVESTMENT STRATEGY, AMERICAS, AND THOMAS F. GUARINI, PRODUCT SPECIALIST, STATE STREET GLOBAL ADVISORS beyond the black and white divides, it becomes clear that combining passive and active investment strategies is actually the most beneficial approach for portfolios, especially when considering the growth of advanced indexes. That is, while certain efficient asset classes may be best accessed with low cost passive investments, others may have greater potential for and passive solutions can complement each other within asset classes and allows investors to tilt portfolios to the best opportunities within and across markets. This approach harnesses the best of passive and active and can help build the most cost effective, resilient and robust portfolios possible. THE EVOLUTION OF PASSIVE INVESTING The debate over the merits of active management ignited in 1965 with the publication of Michael Jensen s The Performance of Mutual Funds in the Period Proponents of passive investing, also known as index investing, typically view markets benchmark, passive investors seek to track the performance of a market index by owning the same assets, in similar proportions, as the underlying index. In contrast, active investors tend to tend to over and underweight securities, sectors or countries in order to generate excess returns relative to an index. share over the past few years. Interestingly, passive investing only to track a rules-based index. Thus, in the grand scheme of the investing world, passive remains a relative newcomer. Much of passive s asset growth was sparked by recent prolonged periods of market volatility starting in the early 2000s when many active managers failed to live up to expectations. The Global Financial Crisis exacerbated this trend and caused investors to reassess the role of active investment approaches, especially passive assets, as a percentage of total mutual fund industry assets, have risen from approximately 10% in 2001 to 26% today. FIGURE 1: THE MARKET SHARE OF PASSIVE HAS GROWN STEADILY Active Passive ETF ACTIVE AND PASSIVE IN DETAIL Fama in 1965, contends that stocks will always trade at a fair value stock can be deemed over- or undervalued at a given point in time. Therefore, passive investing believes that investors are better off owning the entire market rather than trying to make a call on the time, a passive approach is generally less costly to manage and can be passed onto shareholders through lower fees. Passive Source: Morningstar Direct, as of 12/31/2012. Mutual Fund data is exclusive of Money Markets and Fund of Funds

2 In practice, a passively managed large-cap fund would own all 500 stocks listed in the S&P 500 Index. Importantly, a recent trend in passive management is toward advanced indexing or smart beta approaches that harness certain premiums that exist in On the other hand, traditional active investing seeks to outperform the market. To do so, an active large-cap manager would attempt indexed portfolios, which have no discretion to adjust portfolios in declining markets, an actively managed fund could hold more management proponents also believe that highly skilled managers can successfully predict market downturns and that this downside protection can compensate for any periods of underperformance. to identify the funds that beat their benchmarks on a consistent majority of active managers fail to outperform over the long- managers with the most consistent track records. In addition, with some of the approaches that active managers have historically used to generate excess returns, but do so systematically. periods of underperformance, the fact is that certain managers have long exhibited the ability to generate excess returns. In addition, certain markets may be ready for skilled managers to add value. There may also be places where markets are less investable, so an index-based approach may not live up to its stated goals. ACTIVE MANAGEMENT IN PRACTICE Because active management is no longer the default, factors from data, drive decisions on where and how to invest. Since its inception performance analysis supports the notion that passive investing is most fruitful in most, but not all asset classes. study, 63.25% of large-cap funds, 80.45% of mid-cap funds and 66.5% of small cap funds lagged behind their respective S&P indices. In other words, most active managers failed to ETFs: THE MOST ATTRACTIVE INDEX CHOICE there is considerable variability in terms of expense and tax the most attractive choice when considering the impact the expenses and capital gains can have on overall performance. 99% of ETFs are passively managed and seek to track an exchanges, they can be bought and sold at any time during the trading day, unlike mutual funds. In addition to providing investors with easy access to a wide range of securities, market sectors, geographies and investment strategies, ETFs are often Figure 2 highlights this in detail across multiple categories. of portfolio turnover related to portfolio manager decisions. when the portfolio manager must sell securities to raise cash for redemptions. This distribution is taxable to the investor regardless of how long he or she held the fund shares. FIGURE 2: ETFs HAVE LOWER AVERAGE EXPENSE RATIOS VERSUS MUTUAL FUNDS ASSET CLASS INDEX MUTUAL FUND AVERAGE EXPENSE RATIO ETF AVERAGE EXPENSE RATIO ETF EXPENSE ADVANTAGE Mid Cap Value Small Cap Value Small Cap Growth Mid Cap Growth Large Cap Growth Large Cap Value Small Cap Blend International Large Cap Blend Mid Cap Blend Fixed Income Emerging Markets Source: Morningstar Direct, SSgA, as of 12/31/2012. Sidebar continues on next page 2

3 Sidebar continues from page 2 FIGURE 3: ETFs HAVE EXPERIENCED MUCH LOWER CAPITAL GAINS THAN MUTUAL FUNDS AVERAGE MUTUAL FUND CAPITAL GAIN DISTRIBUTION AVERAGE ETF CAPITAL GAIN DISTRIBUTION Source: Morningstar Direct, SSgA, as of 12/31/2012. historically have been substantially lower than that of mutual funds. For most investors, ETFs are bought and sold on the shares, there is no impact to the portfolio because the portfolio redemption. Very large purchases and redemptions are handled with the creation or redemption of ETF shares as a basket trade with market makers. These in-kind transactions are not tax bite. Finally, the broad range of ETFs enables investors to reach every corner of the market across asset classes. Therefore, in traditional core asset classes, ETFs can also serve as low-cost satellites to express particular sector or geographical bets costs such that they may offset any savings from lower fees. keep pace with a rising market. Only large-cap growth and real estate funds outperformed their indices last year. Furthermore, yielded similar results, with only large-cap value maintaining performance parity relative to its benchmark. Interestingly, although international and emerging markets are 56% of international funds and close to 58% of emerging markets funds underperformed relevant S&P benchmarks over the past international small-cap funds that outperformed the benchmark, regardless of the period being measured, indicating that active management adds value here, most likely due to the lack of analyst coverage and low trading volume of the underlying securities. benchmark indices except for long-term government, investment picture becomes more mixed. When viewed over the most recent the categories lagged behind the benchmark indices, except for intermediate investment grade funds. results on a yearly basis? While you could do so in an attempt to embrace the best of active or passive, remember that past conditions to consider what factors may be at play. What in the 2012 market environment helped active large-cap growth and real estate managers to outperform when most Why do international small cap managers consistently perform such a wide margin? Why does active management do so well consistently in investment grade intermediate, but not in high yield? Why is the average return of global income funds so much this actually the right benchmark to judge these managers? across all markets and asset classes? In other words, can these rosy results actually be harnessed by passive managers since indexes are not investable? It may be helpful to dig deeper into performance percentages majority of managers in a category underperform the benchmark, the outperformance could be substantial, making an investment in an active fund more rewarding. Thus, if in fact it pays to go active in these situations, investors must ensure they do their due 3

4 FIGURE 4: PERCENTAGE OF US EQUITY FUNDS OUTPERFORMED BY BENCHMARKS FUND CATEGORY All Domestic Equity Funds COMPARISON INDEX 1 YEAR 3 YEARS 5 YEARS S&P Composite All Large-Cap Funds S&P All Mid-Cap Funds S&P MidCap All Small-Cap Funds S&P SmallCap All Multi-Cap Funds S&P Composite Large-Cap Growth Funds S&P 500 Growth Large-Cap Core Funds S&P Large-Cap Value Funds S&P 500 Value Mid-Cap Growth Funds S&P MidCap 400 Growth Mid-Cap Core Funds S&P MidCap Mid-Cap Value Funds S&P MidCap 400 Value Small-Cap Growth Funds S&P SmallCap 600 Growth Small-Cap Core Funds S&P SmallCap Small-Cap Value Funds Multi-Cap Growth Funds S&P SmallCap 600 Value S&P Composite 1500 Growth Multi-Cap Core Funds S&P Composite Multi-Cap Value Funds Real Estate Funds S&P Composite 1500 Value S&P BMI United States REIT Source: S&P Dow Jones Indices, CRSP. For periods ended December 31, Outperformance is based upon equal weighted fund counts. All index returns used are total returns. Charts are provided for illustrative purposes. Past performance is not a guarantee of future results. other income. FIGURE 5: PERCENTAGE OF INTERNATIONAL EQUITY FUNDS OUTPERFORMED BY BENCHMARKS FUND CATEGORY COMPARISON INDEX 1 YEAR 3 YEARS 5 YEARS Global Funds S&P Global International Funds S&P International Small-Cap Funds Emerging Markets Funds S&P Developed Ex-U.S. SmallCap S&P/IFCI Composite Source: S&P Dow Jones Indices, CRSP. For periods ended December 31, Outperformance is based upon equal weighted fund counts. All index returns used are total returns. Charts are provided for illustrative purposes. Past performance is not a guarantee of future results. other income. this consideration remains paramount when judging managers. INTEGRATING ACTIVE AND PASSIVE STRATEGIES The de-risking of portfolios that started in the last decade opened the door for an increased appreciation for passive investing and advanced indexing. Today investors continue to explore the broader role that index funds can play in their overall portfolio. Therefore, individual management style and investor timeframe The lower cost of passive funds may make them more practical positions with higher turnover strategies. One factor that could point you to an active fund for a long-term buy-and-hold position is that while passive funds outperformed most active funds over the last several years, the longer term rankings of each index relative passive s performance victory is not so clear cut across all asset classes. In addition, passive funds may serve well as a means to best augment longer-term positions with more tactical investment a successful manager when their approach is most in favor. FIGURE 6: ACTIVE / PASSIVE MANAGEMENT MATRIX PASSIVE PORTFOLIO MANAGEMENT ACTIVE PORTFOLIO MANAGEMENT Passive / Passive Buy-and-hold using passively Active / Passive Active management of passively Passive / Active Buy-and-hold using actively Active / Active Active management of actively Passive/Combined Passive & Active Buy-and- hold using a blend of passively and actively Active/Combined Passive & Active Active management of a blend of passively and actively 4

5 FIGURE 7: PERCENTAGE OF FIXED INCOME FUNDS OUTPERFORMED BY BENCHMARKS FUND CATEGORY COMPARISON INDEX 1 YEAR 3 YEARS 5 YEARS Government Long Funds Barclays Long Government Government Intermediate Funds Barclays Intermediate Government Government Short Funds Barclays 1 3 Year Government Investment-Grade Long Funds Barclays Long Government/Credit Investment-Grade Intermediate Funds Barclays Intermediate Government/Credit Investment-Grade Short Funds Barclays 1 3 Year Government/Credit High Yield Funds Barclays High Yield Mortgage-Backed Securities Funds Barclays Mortgage-Backed Securities Global Income Funds Barclays Global Aggregate Emerging Markets Debt Funds Barclays Emerging Markets General Municipal Debt Funds S&P National AMT-Free Municipal Bond California Municipal Debt Funds S&P California AMT-Free Municipal Bond New York Municipal Debt Funds S&P New York AMT-Free Municipal Bond Source: S&P Dow Jones Indices, CRSP. For periods ended December 31, Outperformance is based upon equal weighted fund counts. All index returns used are total returns. Charts are provided for illustrative purposes. Past performance is not a guarantee of future results. through index funds in a portfolio s core with the potential to add alpha in satellite positions. In many portfolios, the vehicle of choice for the combination approach is the ETF. Importantly, rather than use passive funds simply as cost-effective alternatives to actively, today savvy investors are integrating passive funds with active funds. That is, whereas they once might have invested in passive funds to gain inexpensive access have convinced investors that there may be advantages to using passive investing to access a wider set of market betas. In short, passive and active management are no longer mutually exclusive from an investment philosophy or portfolio construction standpoint. Conversely, investors can use the core and explore and avoid style drift by taking the opposite approach, thereby placing active managers at the core using passively managed products For example, consider how an investor could augment an actively market dividend growers and emerging market local currency and corporate debt. CONCLUSION Going forward, active managers may not face the same headwinds that they did in the past several years. These have included continued periods of high volatility and correlations that certain investment styles come in and out of favor depending upon underlying market conditions. For example, certain active managers do well in trending markets, while others may do best when markets reward companies that have been the most beaten up. passive funds can now serve as both a replacement and portfolio between passive and active management depends on active managers. Whether your goal is low-cost core exposure, allocation, or implementing tactical portfolio decisions, passive funds, including ETFs, can be an important portfolio addition. 5

6 ETF RESOURCES AT STATE STREET GLOBAL ADVISORS ABOUT SPDR ETFs & SPDRS.COM through the introduction of many ground-breaking products, including SPDRS.COM For rich ETF content, tools and comprehensive information on our ETFs, visit us at spdrs.com. While you re there, don t forget to check out our PORTFOLIO ANALYZER - a web-based portfolio analysis and proposal PORTFOLIO CONSTRUCTOR - a comprehensive web-based portfolio CORRELATION TRACKER - allows you to run correlations among ETFs, mutual funds, individual stocks and even portfolios using total returns. ETF SCREENER SALES AND MARKETING For more information about our ETFs or how to invest, please call SPDR ETF SALES STRATEGY GROUP of world class investment content and client-focused consulting services across asset classes, the group works to develop and implement investment themes and product ideas while also providing investment Sales Strategy, ETFSalesStrategy@ssga.com. SPDR CAPITAL MARKETS GROUP management expertise, detailed product analysis, and ETF trade implementation to investors, with the goal of educating clients on the investment presence, the group provides industry insight, thematic market trends, and world class support to institutional investment management Global Capital Markets Group, ETF_Global_Capital_Markets@ssga.com. BLOOMBERG PAGE SPDR UNIVERSITY (SPDRU.COM) educational content. With tools and information you can put into practice, best practices for managing your business. Learn more and go to today. STATE STREET GLOBAL ADVISORS State Street Financial Center One Lincoln Street FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE. IMPORTANT RISK INFORMATION ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns. Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Bond funds contain interest rate risk (as interest rates rise bond prices usually fall). There are additional risks for funds that invest in mortgage-backed and asset-backed securities including the risk of issuer default; credit risk and inflation risk. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as reation units. Please see the fund prospectus for more details. Information represented in this piece does not constitute legal, tax, or investment advice. Investors should consult their legal, tax, and financial advisors before making any financial decisions. Passive management and the creation/redemption process can help minimize capital gains distributions. Actively managed products are subject to the risk that the investments selected by the Adviser may cause the product to underperform relative to its benchmark or other funds with a similar investment objective. Barclays is a trademark of Barclays, the investment banking division of Barclays Bank PLC ( Barclays ) and has been licensed for use in connection with the listing and trading of the SPDR Barclays ETFs. The products are not sponsored by, endorsed, sold or promoted by Barclays and Barclays makes no representation regarding the advisability of investing in them. SPDR is a registered trademark of Standard & Poor s Financial Services LLC ( S&P ) and has been licensed for use by State Street Corporation. STANDARD & POOR S, S&P and S&P 500 are registered trademarks of Standard & Poor s Financial Services LLC. No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P or its affiliates, and S&P and its affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/shares in such products. Further limitations and important information that could affect investors rights are described in the prospectus for the applicable product. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call or visit spdrs.com. Read it carefully State Street Corporation. All Rights Reserved. ID0194-IBG Exp. Date: 4/20/2014 IBG.EDU.LAPIA