The best of both worlds A look at the complementary nature of active and passive investing
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- Godwin Parker
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1 PART 1: Introduction The best of both worlds A look at the complementary nature of active and passive investing Although the active versus passive investing debate may continue in the media, 2013 proved to be an interesting year, and one in which the alleged debate may have come to its logical conclusion. So who won this so-called debate? Well, both investment styles. Far from a debate, research continues to show that active and passive investing are complementary approaches from a portfolio perspective. Why? Because different markets, at different times, behave in different ways. What was once efficient (ideal for passive) can become inefficient (ideal for active). This paper explains why the strongest investment portfolios from the perspective of diversification, performance and risk management have a healthy allocation to both active and passive investment solutions. And that having a manager, like Sun Life Global Investments (Canada) Inc., who can tactically maneuver between the two is akin to having the best of both worlds. And the winner is Nobel Prize awarded to contradictory theories Before getting into the hard data, here s a story that provides quick anecdotal evidence that for successful professional investors the active and passive debate is coming to an end. In an unexpected move, the 2013 Nobel Prize in Economic Sciences* was awarded to Eugene Fama and Robert J. Shiller, which at first glance seems ironic because the work of these two brilliant economists contradicts one another. Fama is considered by many to be the father of efficient market hypothesis, and his research supports the case for index investing. Shiller, on the other hand, has been working at showing the limitations of efficient markets theory. Clearly, that Fama and Shiller both won what is arguably the highest recognition for economic research and in the same year validates the argument for both investment approaches. * The Sveriges Riksbank Prize in Economic Sciences In Memory of Alfred Nobel is the actual name of the Nobel Prize in Economic Sciences.
2 PART 2: The Rotman study When active management pays New evidence from Canada and the U.S. A recent study out of the Rotman School of Management in Toronto and the David Eccles School of Business in Utah outlined where active and passive managers are effective and why. In the study Does Management Pay? New International Evidence *, the authors indicate that the view surrounding passive management is skewed as a result of: Using data from highly efficient markets (for example, the U.S. equity market) Not accounting for investor sophistication (professional money managers have a better record of choosing outperformers) Efficient versus inefficient markets Overall, the Rotman study s results suggest that the value of active management depends on the efficiency of the underlying market and the sophistication of the investor. As such, institutions use active management more frequently in non-u.s. markets. For example, sophisticated institutional investors benefited from active management over passive management in the Europe, Australasia and Far East (EAFE) and emerging markets regions between 1993 and 2008 by 50 basis points (bps) and 250 bps, respectively. How did they manage this? Institutional investors are more likely to gain alpha through active management as they provide oversight and have a greater amount invested in international relationships. In U.S. equity markets, which are generally highly efficient, active management has tended to underperform. This will be discussed in further detail in the following pages. The Rotman study, however, also found that active managers have outperformed in the U.S. equity space during down markets, providing evidence that active managers can offer reduced downside participation during volatile periods. For sophisticated institutional investors, active management outperforms passive management by more than 250 bps per year in emerging markets and by about 50 bps in EAFE markets over the 1993 to 2008 period. Karl V. Lins and Lukasz Pomorski * Karl V. Lins and Lukasz Pomorski, Does Management Pay? New International Evidence PAGE 2
3 PART 3: Examining historical returns A time for active and a time for passive Looking at active management across asset classes To build a deeper insight into the roles played by active and passive management in portfolio construction, Sun Life Global Investments analyzed the median manager of different asset classes (for example, Canadian equities and global real estate) against their respective benchmarks. The active manager s performance was compared to the benchmark over one-year time periods from December 31, 2004 to December 31, 2013, as well as the 10-year annualized rate of return ended December 31, The relative standard deviation and reward-to-risk ratio were also examined in a similar manner. The data revealed some interesting facts. Namely, that active management has consistently outperformed over longer time periods, while shorter-term returns are more mixed. The data also revealed that diverse market environments (for example, a period of heightened market volatility or a period of relative calm) will impact whether or not active or passive management outperforms. outperforms over the long term 10-year annualized returns (ended December 31, 2013) 1.50% 1.17% 1.00% 0.50% 0.62% 0.20% 0.36% 0.30% 0.44% 0.82% 1.02% 0.00% Canadian equity Canadian fixed income U.S. equity International equity Emerging market equity Global equity Global fixed income Global real estate ACTIVE-MEDIAN MANAGER VERSUS PASSIVE BENCHMARK Canadian equity Fixed income U.S. equity International equity Specialty equity PAGE 3
4 PART 3: Examining historical returns Canadian fixed income On an annual basis, the median active manager outperformed passive (as measured by the DEX Universe Bond Index) in 2006, 2009 and 2010, and again in 2012 and The Canadian bond market is unpredictable and inefficient, and whether an active or passive solution is the better approach depends on the overall economic and market environment. A talented professional investment manager can help ensure that a portfolio is benefiting from an appropriate allocation between the two. For example, during the 2008 financial crisis, corporate bond spreads increased dramatically. In 2009, as the markets recovered, the spreads started to narrow considerably. An active manager could have taken advantage of this and weighted their bond portfolio in favour of corporate bonds, leading to outperformance over the broad index, which typically holds a significant weighting in government bonds. In the coming years, interest rates and yields will be rising - not ideal conditions for Canadian bonds. This environment may seem to be favourable for active managers who can selectively choose appropriate bonds to help protect downside risk. Canadian equity Over the past 10 years, the median active manager outperformed the passive index as measured by the S&P/ TSX Capped Composite Index seven times on a one-year basis. In 2013, this disparity was made palpable as active outperformed passive by 5.1%. This is likely because of the economic environment. In 2013, the materials sector (which makes up a substantial portion of the Canadian equity market) significantly underperformed because of falling gold prices. An active manager could diversify out of the materials sector, while a passive investment is bound to that underperforming exposure. As witnessed in 2013, concentration issues in Canadian equities seem to be the biggest issue for being passive. When those few sectors outperform, however, passive managers shine. vs. passive Canadian fixed income 0.0% 0.1% 0.1% 0.2% 0.4% 0.3% 0.6% 0.5% 1.4% -median bond universe manager 2.9% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% Based on monthly Mercer MPA Pooled Canadian Fixed Income gross returns from January 1, 2004 to December 31, is the DEX Universe. vs. passive Canadian equity 0.4% 1.2% 1.1% 1.0% 0.8% 1.0% 1.1% 1.3% 1.9% -median core manager 0.62% 5.1% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% Based on monthly Mercer MPA Pooled Canadian Equity gross returns from January 1, 2004 to December 31, is the S&P/TSX Capped Composite. PAGE 4
5 PART 3: Examining historical returns vs. passive Global fixed income vs. passive Global real estate 0.1% 1.2% 0.7% 0.4% 1.3% 0.3% 2.5% -median global bond manager 6.5% 7.6% 8.3% 1.7% 9.7% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% Based on monthly Mercer MPA Pooled Global Fixed Income (PFS) gross returns from January 1, 2004 to December 31, is the Citigroup World Broad Investment Grade Index (Citi WBIG). 2.0% Global fixed income management can outperform in the global fixed income space, as measured against the Citigroup World Broad Investment Grade Index. The median active manager consistently added value, outperforming in six of the past 10 years, and delivered substantial excess returns in 2009, 2010 and 2012 (9.7%, 6.5% and 7.6%, respectively). There are a number of reasons why active management tends to outperform in the global fixed income space, including the fact that this asset class is generally under-researched, making it somewhat easier for asset managers with effective research methods to find undervalued investments. Despite underperforming in 2008, and having benchmarklike returns in 2011, the chart below shows that the standard deviation was much lower than the benchmark (6.5% less in 2008). Therefore, on a risk-adjusted basis, active global fixed income managers added value. global fixed income standard deviation vs. the benchmark 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% -median global fixed income manager relative deviation 0.7% 1.5% Based on monthly Mercer MPA Global Fixed Income (PFS) deviations from January 1, 2004 to December 31, is the Citigroup World Broad Investment Grade Index. 0.1% 0.3% 0.5% 0.4% 1.2% -median global real estate manager 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% Based on monthly Mercer MPA Global Real Estate Securities (USD) gross returns from January 1, 2004 to December 31, is the FTSE NAREIT EPRA Developed. Global real estate The median active manager outperformed the FTSE NAREIT EPRA Developed Index in nine of the past 10 years. The excess return of active managers highlights the concept that in less liquid, less traditional asset classes, active management tends to add value. In an asset class that is traditionally less researched, active managers can add value through independent research and analysis. PAGE 5
6 PART 3: Examining historical returns Emerging markets equities The median active manager outperformed five of 10 years, which is likely because these regions tend to be under-researched compared to their developed market peers. An insightful active manager can generate alpha through both country and stock selection. They may also have the potential to avoid countries that are underperforming due to political and economic constraints, which is not possible with a passive instrument. What about the U.S.? It s important to return to the case of U.S. equities. management was less successful than passive management in U.S. equities, which lines up with the Rotman study s assumption that the U.S. equity market is generally quite efficient. However, in the last 10 years, the annual outperformance was evenly split between active and passive. Effective active managers can add value via in-depth research and cash flow analysis, especially in periods of heightened market volatility. In more efficient markets, there is always an opportunity for active managers to potentially add an additional layer of downside protection. Passive generally outperforms in U.S. markets Nevertheless, Sun Life Global Investments analysis found that the standard deviation of active managers was slightly higher than that of the passive benchmark, while the reward-to-risk results were relatively similar so even on a risk-adjusted basis, passive outperformed active in U.S. equity markets. vs. passive Emerging markets vs. passive U.S. equity 0.0% 0.3% 0.2% 0.6% 0.9% 1.0% 0.9% 1.3% 1.3% 1.7% 2.0% 2.0% 2.5% -median emerging markets equity manager 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% Based on monthly Mercer MPA Pooled Emerging Markets gross returns from January 1, 2004 to December 31, is the MSCI EM. 2.0% -median U.S. equity manager U.S. equity standard deviation vs. the benchmark 1.2% 2.00% 1.5% 0.8% 0.00% 0.2% 2.1% -2.00% -median U.S. equity manager relative deviation Based on monthly Mercer MPA Pooled U.S. Equity gross returns from January 1, 2004 to December 31, is the S&P % 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% Based on monthly Mercer MPA Pooled U.S. Equity gross returns from January 1, 2004 to December 31, is the S&P 500. PAGE 6
7 PART 4: Tactical active/passive PART 3: Examining Sun Life Granite historical Portfolios returns Sun Life Granite Managed Portfolios The best of both active and passive As previously discussed, asset classes efficient or inefficient perform differently in diverse market environments. For example, passive strategies may outperform during periods of market stability, whereas active managers may outperform during times of relatively high volatility and can potentially provide an additional layer of risk management through reduced downside participation. The performance of active and passive investing tends to depend on the asset class and the market environment. Ultimately, however, expert portfolio management can make the greatest difference. Take Sun Life Granite Managed Portfolios for example. Each are managed with the belief that, from an overall portfolio perspective, the active and passive investment approaches are complementary and have clearly defined roles. And it s the portfolio manager s responsibility to know when to tactically reallocate assets between active and passive strategies. Example: The underlying solutions in Sun Life Granite Target Date Funds The Portfolios fixed income, Canadian equity and U.S. equity exposures benefit from both active and passive managers, as each of these markets can be highly efficient at times, for better or worse. For example, the Canadian equity market is largely composed of three sectors financials, energy and materials and when one of these sectors begins to underperform (as the materials sector did in 2013), being able to actively diversify out of that sector is a considerable advantage for investors. When a market environment like this occurs, Sun Life Granite Managed Portfolios can rotate out of the passive solution and into an active one in order to reduce the risk of the portfolio. In less efficient areas of the market, including asset classes like international equities, global bonds or real estate, active managers can use their expertise to outperform or manage risk. Sun Life Global Investments has a rigorous manager selection process that closely examines track record, risk management, organizational structure, strength and strategy, investment philosophy and experience, to name just a few of the qualities that are looked for. Only after this thorough review process is a manager chosen to represent an asset class within Sun Life Granite Managed Portfolios. Fixed Income Sun Life Financial Money Market Sun Life BlackRock Canadian Universe Bond Sun Life Financial Universe Bond (Beutel Goodman) Templeton Global Bond RBC Global High Yield Bond Canadian equity Beutel Goodman Canadian Equity MFS Canadian Equity Growth Sun Life BlackRock Canadian Composite Equity U.S. equity TD Hedged Synthetic U.S. Index Sun Life MFS U.S. Growth International equity Sun Life MFS International Value Sun Life MFS International Growth Sun Life Schroder Emerging Markets Specialty equity Lazard Global Listed Infrastructure Invesco Global Real Estate Passive Passive Passive PAGE 7
8 PART 4: Tactical active/passive in Sun Life Granite Portfolios Sun Life Global Investments: Strategic views for Sun Life Granite Target Date Funds Asset class/ Strategic Investment Views Fixed Income Longest Maturity Fund shortest maturity fund Cash None 10% Bond domestic/foreign mix Domestic Bond active/passive mix Canadian equity Equity domestic/foreign mix Domestic Equity active/passive mix U.S. equity U.S. Equity active/passive mix (US$ hedged) International equity International (incl. Emerging Markets) specialty equity Specialty Equity Infrastructure & REITs 50% domestic 100% foreign /50% foreign Constant (50% active/50% passive) More Foreign (30% domestic/ 70% foreign) 100% active Constant (50% active/50% passive) Constant (100% active) 50% domestic /50% foreign 100% passive (hedged) 15% Constant 5% (100% active) Overall, 12.50% (longest maturity) to 31.25% (shortest maturity) is passively managed* Keys roles of active and passive Here is a quick look at why Sun Life Global Investments chooses active and passive managers for Sun Life Granite Managed Portfolios. managers are added to: Help manage portfolio risk Enhance potential returns through alpha Access diversifiers where affordable reduce volatility (vs. index profile) and seek to reduce downside capture help navigate through turbulent market environments overcome the fact that some standard passive indices are inefficiently constructed (e.g., infrastructure) Passive funds are used to: help gain efficient market exposure (e.g., where the potential value add from active management is expected to be lower or to provide low-cost exposure) Provide the ability to increase or decrease the portfolio s active/passive exposure depending on the outlook for performance of active managers control manager style risk * Subject to change based on tactical views. When it comes to constructing successful investment portfolios, Sun Life Global Investments believes investors should reject the active versus passive debate. Instead, investors should embrace a more holistic understanding of how active and passive investment management are complementary, and can be used to generate attractive riskadjusted returns over longer time periods. To learn more about how Sun Life Global Investments uses active and passive investing to build Sun Life Granite Managed Portfolios, please contact: Pat Leo Director, Institutional Business Development, Ontario and Western Canada Sun Life Global Investments pat.leo@sunlife.com Anne Meloche Regional Vice-President, Institutional Business, Quebec and Eastern Canada Sun Life Global Investments anne.meloche@sunlife.com Sun Life Financial Target Date Funds are segregated funds of Sun Life Assurance Company of Canada, managed on a sub-advisory basis by Sun Life Global Investments (Canada) Inc. Sun Life Global Investments (Canada) Inc. is a member of the Sun Life Financial group of companies. Sun Life Global Investments (Canada) Inc., FOR INSTITUTIONAL USE ONLY
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