A NEW MIDDLE GROUND. in the Active versus Passive Debate

Transcription

1 A NEW MIDDLE GROUND in the Active versus Passive Debate

2 Once there was no more polarizing debate than the active versus passive investment management question. Active management is an investment strategy based on using research to select specific stocks and bonds to build a portfolio. By evaluating everything from companies finances to industry conditions and the health of the overall economy, active managers believe their security selections can lead them to identify investments that will beat the market. Therefore, an active large-cap equity fund might own 50 to 200 of what the manager believes to be the most attractive companies in the S&P 500 Index, with the goal of outperforming the index. Because trading of stocks and bonds occurs more frequently and research is required to identify suitable investments, costs tend to be higher for active funds. Proponents of active investing argue that the extra costs are justified because of the potential for an active fund to outperform the index, or its benchmark. Passive management is an investment strategy based on the notion that the market is efficient, or that stocks will always trade at a fair price that reflects all available market information. A passive fund manager owns all the stock and bonds in a particular market and does not invest by making market forecasts or personal judgments. Therefore, a large-cap passive fund, or an index fund, would own all 500 stocks in the S&P 500 Index. Because the manager makes adjustments to the fund only to reflect changes in the index, trading costs are low. Additionally, reduced trading of stocks and bonds can increase the fund s tax efficiency.

3 Traditionally, active investors have viewed passive investing as settling for average performance while passive investors regarded active investing as as not worth the extra costs. However, the traditionally heated debate between disciples of the two approaches may be cooling. In fact, many investors are re-thinking what it means to be a passive or an active investor and deploying assets in a way that reflects new, less polarizing definitions. In fact, an investment approach referred to as smart beta is further blurring the lines between active and passive management. Smart beta is a rules-based investment strategy that seeks to capture specific factors in the marketplace that active managers have historically relied on to outperform. These include value, size, low volatility, quality and momentum. Combining the ability to take an active view on which risk factors may outperform over time with the transparency, liquidity and flexibility of passive investing, smart beta portfolios seek to deliver returns in a more cost-efficient way than active management. With the potential for generating attractive long-term risk-adjusted performance, smart beta strategies may effectively complement both active and passive investment approaches. Today, with more choices than ever, investment philosophy, personal goals, and even the market cycle dictate how investors combine active and passive funds to create portfolios where the sum total can be greater than the individual parts. 3

4 The Debate s Academic Roots Before exploring how passive and active investing can work together, it s important to understand that the two approaches have historically been divided by a passion akin to the Red Sox/ Yankees or Microsoft/Apple rivalries. As mentioned, the philosophical sound and fury stems from opposite answers to a fundamental investment question: Are the markets efficient? The Efficient Market Hypothesis (EMH) provides the framework for passive investment management. Developed by Nobel Laureate Eugene Fama in 1965, EMH contends that securities will always trade at a fair value price that reflects all available market information. Therefore, if no security can be over- or under-valued at a given point in time, instead of trying to beat the market, passive managers simply own all the stocks or bonds in the same proportions as the index. Conversely, active investors believe that markets are inefficient, or that there is information that skilled managers can uncover and exploit, leading to superior returns versus an index. Therefore, active managers seek to invest in what they see as the most attractive stocks and bonds, based on their own investment philosophy and market outlook. Notably, these philosophical differences, which result in more research and trading for active managers, impact a fund s cost. According to Morningstar, the average expense ratio for passive Exchange Traded Funds (ETFs) is 0.60% versus 1.24% for the average active mutual fund. 1 Additionally, active managers higher level of trading also can result in more capital gains distributions at year-end, making active funds generally less tax-efficient than passive funds. What Approach Performs Better? Research suggests that active management at the individual stock level is not worth the additional costs for most asset classes. Traditionally, only US small-cap and emerging markets funds, where there are more securities to choose from and less access to information, have generally been considered prime for active management. Twice a year, S&P Dow Jones Indices LLC publishes an active/ passive scorecard. According to the SPIVA U.S. Year-End 2015 Scorecard, 66.11% of all large-cap managers underperformed the S&P 500 benchmark during the past one-year period. Over the five- and 10-year investment horizons, 84.15% and 82.14% of large-cap managers, respectively, failed to deliver incremental returns over the benchmark. Additionally, 56.81% of all mid-cap managers failed to beat the S&P MidCap 400 Index over the one-year period and 72.2% of active small-cap funds lagged the S&P SmallCap 600 Index. Over five- and 10-year horizons, an overwhelming majority, 76.69% and 87.61% of actively managed mid-cap funds and 90.13% and 88.42% of small-cap funds underperformed their respective benchmarks.* Of course, there are active managers who are able to outperform, in some cases consistently, over longer periods of time. However, it takes time and skill to find and hire them. Also, given that investment styles come in and out of favor, being ahead of benchmarks all the time is unlikely. And, notably, some of the underperformance of active funds can be attributed to fees that diminish the funds returns. * Past performance is not a guarantee of future results. 4

5 Figure 1: Market Landscape of Active vs. Passive Percentage of US Equity Funds Outperformed by Benchmarks S&P 500 Large-Cap Core Funds S&P MidCap 400 Growth Mid-Cap Growth Funds S&P SmallCap 600 Growth Small-Cap Growth Funds 73.8 % 88.3 % 82.8 % 79.9 % 81.5 % 91.2 % 88.4 % 91.9 % 92.4 % One-Year Five-Year Ten-Year Source: S&P Dow Jones Indices LLC, CRSP. Data as of December 31, Outperformance is based upon equal weighted fund counts. All index returns used are total returns. Past performance is no guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. While past performance is not predictive of the future, history suggests that the future environment for stock pickers may improve after a particularly difficult five-year period for active management. In particular, active managers tend to perform well in volatile market cycles because they do not have to own every stock in the benchmark and can avoid underperforming stocks. And, with the Federal Reserve beginning to hike interest rates, investors may benefit from being more active in fixed income markets. Passive s Growing Momentum Even though the majority of active investors underperformed their benchmarks in recent years, the majority of US retail assets are still invested in actively managed strategies. That long-standing characterization may have its roots in the fact that the first public actively managed mutual fund was launched in the United States in 1924 while the first passively managed index fund for individual investors wasn t introduced until But the tide is changing. Morningstar reports that in 2015 actively managed US-based mutual funds experienced $207.3 billion of outflows (roughly $169 billion from equity funds) while passive US mutual funds received $413.8 billion. 2 And passively managed assets now account for 28 percent of total industry assets, up from approximately 13 percent in ETFs have been a major contributor to the growth of passive investing. In 2015, ETFs took in $238 billion. 4 In January 2016, ETF assets topped $2.006 trillion. 5 In addition to contributing to the surge in passive s market share, ETFs have also spurred the advancement a new definition of active investing. The increasingly broad array of ETFs gives investors more ways to be active beyond simply selecting stocks and bonds. For example, you can attempt to beat the index by investing in a specific sector or industry ETF. Or you can seek enhanced risk-adjusted returns by rotating across countries or styles, like growth and value. 5

6 Figure 1: What Does it Mean to be an Active Investor? The definition of active investing is changing. Investors can be active on a number of different levels Asset Class Country Sector Industry Company and invest across a spectrum of strategies from fully active to passive. FULLY PASSIVE Index Enhanced Indexing Smart Beta Active Quant Fundamental Alternatives ACTIVELY MANAGED 6

7 How You Can Combine Passive and Active? Just as your gas mileage depends on the car s fuel efficiency and how you drive, both the funds you select and how you manage them can impact returns. That is, beyond the fund management level, active and passive can also describe the individual investor s behavior. Active investors tend to trade more, hoping to take advantage of what they perceive as emerging opportunities. On the other hand, passive investors may set their initial asset allocation and subscribe to more of a buy and hold philosophy over the long-term. As investors seek the most efficient ways to blend active and passive strategies, what it means to be active has become more nuanced. Rather than ask, Are you an Active or Passive investor? a more accurate question might be, Are you Actively Passive or Passively Active? For example, if you invest only in passive index funds, but do a lot of trading, you d be categorized as Actively Passive. Conversely, investing in active funds in a buy-and- hold portfolio would make you Passively Active. Combining Active and Passive Investments Passive Index Mutual Funds & ETFs Actively Managed Mutual Funds & ETFs Strategic Portfolio Management STRATEGIC / PASSIVE Buy-and-hold investing with index funds STRATEGIC / ACTIVE Buy-and-hold investing with actively managed funds Tactical Portfolio Management TACTICAL / PASSIVE Active trading of index funds TACTICAL / ACTIVE Active trading of actively managed funds 7

8 Ideas for Combining Active and Passive We have seen these strategies implemented by our financial advisor and institutional clients. IDEA 1 Equity: Core-Plus Allocation Active Stock Selection. Use passive indexes in the core and active managers in the growth and value styles. The passive core provides a low-cost foundation for a portfolio while active managers offer the potential to add alpha. Stock Selection: Passive Equity Core Plus Styles Value Blend Growth Large Active Large Cap Value Manager Passive S&P 500 Index Active Large Cap Growth Manager Mid Active Mid Cap Value Manager Passive S&P 400 Index Active Mid Cap Growth Manager Small Active Small Cap Value Manager Passive Russell 2000 Index Active Small Cap Growth Manager IDEA 2 Fixed Income: Core-Plus Allocation Invest passively in aggregate bonds and select active managers with expertise in less efficient fixed income sectors. 60 % CORE Barclays Aggregate Bond Index 5 % ACTIVE Emerging Market Debt 10 % ACTIVE High Yield 10 % ACTIVE Senior Loans 15 % ACTIVE ex-us Bonds Source: SSGA. The information contained above is for illustrative purposes only.the information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. 8

9 IDEA 3 Active Core, Passive Satellites Use passive exposure to traditional asset classes with a tactical, multi-asset-class active core. While the multi-asset-class core of active funds remains constant, tactical trading of passive investments serving in a satellite role seeks additional returns. PASSIVE Fixed Income PASSIVE Real Assets and REITs ACTIVE CORE Multi-Asset Class Core Holding PASSIVE Domestic Equity PASSIVE Int l Equity 9 9

10 Looking Ahead: More Art than Science Even as investors integrate these blended strategies into their portfolios, the active/passive debate will continue. How you combine active and passive strategies depends on everything from your investment philosophy, market outlook and sensitivity to fees and the efficiency of various asset classes. The lower cost of passive funds may make them more practical than active funds if you intend to move frequently in and out of positions with higher turnover strategies. And active funds could be suitable for a long-term buy-and-hold position in an asset class where passive funds have not outperformed over the long-term. Or, because passive investments tend to be more tax-efficient than active ones, using a higher proportion of passive funds in taxable accounts may be worth considering. And, the lower volatility that certain active managers provide could prove valuable in times of market stress. The bottom line, as you divide your portfolio between passive and active funds, is that beating the market is not your only goal. Your focus should be on managing your diversified portfolio over the long-term, based on your risk tolerance and personal goals. A trusted financial advisor can help you find an effective balance between active and passive funds and implement strategies to help you meet your investment goals. 1 Morningstar Direct, as of 6/30/2015. Average Net Prospectus Expense ratio for US ETFs and US Mutual Funds as defined by Morningstar. 2 Krouse, Sarah, Investors Snub Money Managers for Market Clones. Wall Street Journal. January 13, Accessed on March 22, 2016 at: wsj.com/articles/morningstar-says-actively-managed-mutual-funds-sawoutflows-in Morningstar, 2015 Fee Study: Investors Are Driving Expense Ratios Down, accessed on November 20, 2015 at study.pdf. 4 Bloomberg Business. Five Key Takeaways From 2015 ETF Flows. January 6, 2016.Accessed on March 16, 2016 at: articles/ /five-key-takeaways-from-2015-etf-flows. 5 Investment Company Institute. Exchange-Traded Funds, January Accessed on March 16, 2016 at: Definitions Active Quant An investment approach that selects securities based on quantitative analysis. Managers build and rely on computer-based models to identify attractive investments. Sometimes buy or sell decisions are made by the model; other times managers use some judgment. Barclays U.S. Aggregate Bond Index A benchmark that provides a measure of the performance of the US dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the US. Capital Gains A profit from the sale of property or of an investment. Enhanced Indexing An investment philosophy that attempts to amplify the returns of an underlying portfolio or index fund while also minimizing the effects of tracking error. A hybrid between active and passive management, the strategy is used in conjunction with index funds and seeks to outperform a specific benchmark. Expense Ratio The annual fee that mutual funds or ETFs charge shareholders. It expresses the percentage of assets deducted each fiscal year for fund expenses, including 12b-1 fees, management fees, administrative fees, operating costs, and other asset-based costs incurred by the fund. Growth In style investing, a strategy that focuses on companies that have the potential to grow their earnings at a high rate. Momentum Stocks whose prices have risen recently. Quality Stocks exhibiting high return on invested capital. REITs Real Estate Investment Trusts (REITs) are companies that own and operate commercial properties, such as office buildings and apartment complexes. Risk-adjusted Returns A concept that refines an investment s return by measuring how much risk is involved in producing a return, which is generally expressed as a number or rating. Risk-adjusted returns are applied to individual securities and investment funds and portfolios. Russell 2000 Index A benchmark that measures the performance of the small-cap segment of the US equity universe. S&P 500 Index A popular benchmark for US large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization. S&P MidCap 400 Index A benchmark that measures the mid-cap segment of the US equity market. S&P SmallCap 600 Index A benchmark that measures the small-cap segment of the US equity market. Smart Beta A set of investment strategies that emphasizes the use of alternative index construction rules to traditional market capitalization based indices. Value In style investing, a strategy that focuses on companies that may be priced below intrinsic value. 10

11 ssga.com For public use. One Lincoln Street, Boston, MA T: State Street Global Markets, LLC, member FINRA, SIPC, One Lincoln Street, Boston, MA The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA s express written consent. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. 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. Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries. Investments in mid-sized companies may involve greater risks than in those of larger, better known companies, but may be less volatile than investments in smaller companies. Investments in small/mid-sized companies may involve greater risks than in those of larger, better known companies. ETFs trade like stocks, are subject to investment risk, 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. Diversification does not ensure a profit or guarantee against loss. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Investing in high yield fixed income securities, otherwise known as junk bonds, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. Value stocks can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. Actively managed funds do not seek to replicate the performance of a specified index. An actively managed fund may underperform its benchmark. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment. Real Estate Investment Trusts (REITS) investing may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrowers. Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Investing involves risk including the risk of loss of principal. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. The trademarks and service marks referenced herein are the property of their respective owners. The S&P 500 Index is a product of S&P Dow Jones Indices LLC (SPDJI), and has been licensed for use by SSGA. Standard & Poor s, S&P and S&P 500 are registered trademarks of Standard & Poor s Financial Services LLC (S&P) State Street Corporation. All Rights Reserved. ID5594-IBG Exp. Date: 03/31/2017