Leveraging the Best of Active and Passive Investment Approaches

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 The active versus passive debate is often emotional and polarizing. However, when you push 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 excess returns and, therefore, are best suited for active management. At the same time, active 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 1945 1965. Proponents of passive investing, also known as index investing, typically view markets as efficient. Accordingly, rather than seek to outperform a 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 believe that markets are inefficient. Therefore, active managers tend to over and underweight securities, sectors or countries in order to generate excess returns relative to an index. Although actively account for nearly three quarters of the overall market, passive funds have gained significant market share over the past few years. Interestingly, passive investing only became a reality in 1971 with the launch of the first fund seeking 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 when many managers experienced liquidity difficulties and marked underperformance during the worst of the crisis. Accordingly, passive assets, as a percentage of total mutual fund industry assets, have risen from approximately 10% in 2001 to 26% today. At the same time, investors of all shapes and sizes have become more cost conscious and are highly scrutinizing management fees. FIGURE 1: THE MARKET SHARE OF PASSIVE HAS GROWN STEADILY 100 80 60 40 20 0 1.5 3.2 3.5 4.5 5.3 6.0 7.3 9.5 10.2 11.2 11.7 12.7 9.8 88.7 9.3 87.5 Active Passive ETF 9.6 86.8 10.5 10.5 10.6 85.0 84.3 83.5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 ACTIVE AND PASSIVE IN DETAIL The Efficient Market Hypothesis (EMH), developed by Eugene Fama in 1965, contends that stocks will always trade at a fair value price that reflects all available information at that time, thus no one 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 relative performance of one security over another. At the same time, a passive approach is generally less costly to manage and can be passed onto shareholders through lower fees. Passive investors stress that less frequent trading reduces a fund s cost 10.7 82.0 11.1 11.3 79.4 78.5 Source: Morningstar Direct, as of 12/31/2012. Mutual Fund data is exclusive of Money Markets and Fund of Funds. 12.3 13.1 13.3 76.5 75.2 74.0 1

and can also improve tax efficiency to enhance after-tax returns. 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 the market with the benefits of a passively managed approach. On the other hand, traditional active investing seeks to outperform the market. To do so, an active large-cap manager would attempt to identify the most attractive 50 to 100 stocks (as identified by their unique investment process) in the S&P 500 Index. Unlike indexed portfolios, which have no discretion to adjust portfolios in declining markets, an actively managed fund could hold more cash, defensively positioning a portfolio in bear markets. Active 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. However, in the investment world beating the average is more difficult to do than in the classroom, on the athletic field or in the workplace. Successful active investing requires that fund managers first identify market inefficiencies. Next, investors have to identify the funds that beat their benchmarks on a consistent basis. And the fact that active managers spend more money on overhead and staffing to support their research and trading makes it even more difficult to beat their benchmarks and be better than average. Adding fuel to the fire are the results of numerous academic studies and evidence from practitioners that find the majority of active managers fail to outperform over the longterm. Skeptics also note that investors need to be able find those managers with the most consistent track records. In addition, with the rise of advanced indexing, investors are now able to utilize some of the approaches that active managers have historically used to generate excess returns, but do so systematically. While active managers are known for finding creative reasons for 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 expense ratios to tax efficiency and, most importantly, performance data, drive decisions on where and how to invest. Since its inception more than a decade ago, the S&P Indices Versus Active Funds (SPIVA) Report has served as an objective scorecard. This annual performance analysis supports the notion that passive investing is most fruitful in most, but not all asset classes. In 2012, although many equity benchmarks posted double digit gains, most active managers across equity categories underperformed their benchmark. According to the 2012 SPIVA 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 While passively managed index funds have many benefits, there is considerable variability in terms of expense and tax efficiency when comparing mutual funds to exchange traded funds (ETF). In many cases, ETFs have the potential to be 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 underlying index. Because ETFs are traded like equities on stock 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 the most cost-efficient option. In fact, ETFs have the potential to offer a significant fee advantage over index mutual funds. Figure 2 highlights this in detail across multiple categories. In addition, ETFs have proven to be more tax-efficient than mutual funds since mutual funds are required to pass any realized capital gains on to investors as a capital gains distribution. These realized capital gains could be the result of portfolio turnover related to portfolio manager decisions. Capital gains can also be realized due to fund redemptions, 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 1.35 0.38 0.97 Small Cap Value 1.38 0.42 0.97 Small Cap Growth 1.19 0.30 0.89 Mid Cap Growth 1.22 0.43 0.78 Large Cap Growth 1.13 0.42 0.71 Large Cap Value 0.95 0.36 0.59 Small Cap Blend 0.76 0.36 0.40 International 0.76 0.48 0.28 Large Cap Blend 0.63 0.42 0.20 Mid Cap Blend 0.58 0.44 0.14 Fixed Income 0.37 0.25 0.12 Emerging Markets 0.68 0.64 0.05 Source: Morningstar Direct, SSgA, as of 12/31/2012. Sidebar continues on next page 2

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 2003 0.13 0.01 2004 0.45 0.03 2005 0.76 0.05 2006 1.03 0.04 2007 1.48 0.08 2008 0.32 0.00 2009 0.04 0.04 2010 0.12 0.06 2011 0.16 0.07 2012 0.18 0.03 Source: Morningstar Direct, SSgA, as of 12/31/2012. Due to ETFs unique structure, capital gains distributions historically have been substantially lower than that of mutual funds. For most investors, ETFs are bought and sold on the secondary market. As a result, when an investor sells ETF shares, there is no impact to the portfolio because the portfolio manager is not required to sell securities to raise cash for the 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 subject to capital gains taxes and can help minimize the overall tax bite. Finally, the broad range of ETFs enables investors to reach every corner of the market across asset classes. Therefore, in addition to serving as a cost-efficient, passive investment in traditional core asset classes, ETFs can also serve as low-cost satellites to express particular sector or geographical bets to boost small cap exposure in equity portfolios and lower duration in fixed income portfolios. However, frequent trading of an ETF could significantly increase commissions and other 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, managers across all domestic equity categories lagged behind the benchmarks over the three-year horizon. The five-year measure yielded similar results, with only large-cap value maintaining performance parity relative to its benchmark. Interestingly, although international and emerging markets are generally thought of as less efficient markets, 66% of global funds, 56% of international funds and close to 58% of emerging markets funds underperformed relevant S&P benchmarks over the past three years. Generally, five year numbers are also reflective of these results. Notably, the SPIVA scorecard found a large percentage of 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. In 2012, most fixed income funds actually outperformed their benchmark indices except for long-term government, investment grade and high-yield funds. Across the three year horizon, the picture becomes more mixed. When viewed over the most recent five year period, actively managed fixed income funds in nearly all the categories lagged behind the benchmark indices, except for intermediate investment grade funds. All of this data begs the question: should you simply divide portfolio assets between passive and active funds according to SPIVA s results on a yearly basis? While you could do so in an attempt to embrace the best of active or passive, remember that past performance is no guarantee of future results. Rather than allocate assets blindly, it may be more beneficial to dig deeper into market conditions to consider what factors may be at play. For example: What in the 2012 market environment helped active large-cap growth and real estate managers to outperform when most other managers in US equity categories failed to do so? Why do international small cap managers consistently perform so well and beat the S&P Developed Ex-U.S. SmallCap Index by 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 better than the Barclays Global Aggregate Index over all time periods on both an equal-weighted and asset-weighted basis? Is this actually the right benchmark to judge these managers? Are passive management strategies available and investable 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 to identify active funds that outperformed. Naturally, investors tend to flock to categories where the majority of fund managers outperformed by a significant margin. However, even when the 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 diligence to find those managers that can consistently outperform. 3

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 1500 66.08 74.35 68.56 All Large-Cap Funds S&P 500 63.25 86.49 75.37 All Mid-Cap Funds S&P MidCap 400 80.45 90.22 90.03 All Small-Cap Funds S&P SmallCap 600 66.50 83.05 82.76 All Multi-Cap Funds S&P Composite 1500 68.15 83.79 79.16 Large-Cap Growth Funds S&P 500 Growth 46.08 90.00 89.67 Large-Cap Core Funds S&P 500 66.29 89.82 78.10 Large-Cap Value Funds S&P 500 Value 85.06 80.78 49.78 Mid-Cap Growth Funds S&P MidCap 400 Growth 87.22 94.20 96.00 Mid-Cap Core Funds S&P MidCap 400 79.66 90.97 89.81 Mid-Cap Value Funds S&P MidCap 400 Value 76.24 78.57 74.49 Small-Cap Growth Funds S&P SmallCap 600 Growth 63.72 87.65 92.23 Small-Cap Core Funds S&P SmallCap 600 68.44 84.73 79.65 Small-Cap Value Funds Multi-Cap Growth Funds S&P SmallCap 600 Value S&P Composite 1500 Growth 61.83 77.60 68.93 52.21 81.78 91.46 Multi-Cap Core Funds S&P Composite 1500 72.68 85.98 78.67 Multi-Cap Value Funds Real Estate Funds S&P Composite 1500 Value S&P BMI United States REIT 73.76 85.62 62.18 47.10 85.71 77.88 Source: S&P Dow Jones Indices, CRSP. For periods ended December 31, 2012. 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. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and 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 1200 63.84 66.26 61.60 International Funds S&P 700 44.25 56.27 73.73 International Small-Cap Funds Emerging Markets Funds S&P Developed Ex-U.S. SmallCap 14.75 9.80 21.05 S&P/IFCI Composite 46.23 57.62 75.51 Source: S&P Dow Jones Indices, CRSP. For periods ended December 31, 2012. 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. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Since it has increasingly become more difficult for outperforming managers to replicate their outperformance in subsequent years, 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 should influence passive versus active investment decisions. 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. 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 to its active peer group illustrates that over longer time horizons, 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 ideas. Active funds may be the best solution to take advantage of 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

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 68.89 97.65 93.75 Government Intermediate Funds Barclays Intermediate Government 30.77 58.54 50.00 Government Short Funds Barclays 1 3 Year Government 39.53 47.73 58.70 Investment-Grade Long Funds Barclays Long Government/Credit 60.74 97.81 94.95 Investment-Grade Intermediate Funds Barclays Intermediate Government/Credit 21.25 36.63 40.18 Investment-Grade Short Funds Barclays 1 3 Year Government/Credit 48.78 64.56 90.36 High Yield Funds Barclays High Yield 74.07 93.56 95.00 Mortgage-Backed Securities Funds Barclays Mortgage-Backed Securities 26.56 34.53 60.00 Global Income Funds Barclays Global Aggregate 21.80 46.43 57.53 Emerging Markets Debt Funds Barclays Emerging Markets 50.85 65.52 60.00 General Municipal Debt Funds S&P National AMT-Free Municipal Bond 29.03 44.44 60.00 California Municipal Debt Funds S&P California AMT-Free Municipal Bond 14.29 50.00 76.19 New York Municipal Debt Funds S&P New York AMT-Free Municipal Bond 21.88 52.94 86.11 Source: S&P Dow Jones Indices, CRSP. For periods ended December 31, 2012. 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. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. A continued trend among investors is the combination of beta 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 for beta exposure, today their finite risk appetite and risk budget 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 as a means to gain access to more specific, timely exposures. For example, consider how an investor could augment an actively managed emerging markets equity fund with low-cost ETFs that provide exposure to emerging small cap equities, emerging 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 across markets with low dispersion making it difficult for managers to select individual securities in the equity and credit markets. Like any investment, active managers may benefit from a reversion to the mean. Even so, investors should be cognizant 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. No longer simply a cost-effective alternative to active funds, passive funds can now serve as both a replacement and complement to active funds. How investors should split a portfolio between passive and active management depends on a number of factors, including specific investment goals and tax circumstances as well as one s level of confidence when selecting active managers. Whether your goal is low-cost core exposure, quick and cost-effective rebalancing back to a strategic asset allocation, or implementing tactical portfolio decisions, passive funds, including ETFs, can be an important portfolio addition. 5

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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. 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