Introduction. As your investment committee evaluates how to best manage your organization s long-term reserve, you will be presented with two alternatives for implementing your strategic asset allocation: active management and passive management, or indexing. Indexing is the optimal solution for a non-profit s long term reserve due to: The influence of asset allocation on the variability of portfolio returns. The relative efficiency of financial markets. The performance of indexed vs. actively managed portfolios. The impact of investment management fees on portfolio returns. Definitions. Active management involves making conscious decisions regarding which investments to include in an investment portfolio. The ultimate goal is to beat the market or outperform a performance benchmark. Active managers hold a portfolio of securities in different proportions than a specified benchmark or index. For example, the Standard and Poor s 500 Index consists of 500 companies weighted within the index based on the market capitalization of each company. While Exxon Mobil represents about 4.0 percent of the S&P 500 Index based on its market capitalization, an active manager may decide to underweight or overweight the portfolio with Exxon Mobil relative to the index weighting. Indexing focuses on mirroring the market and achieving returns that are consistent with a specified index. By indexing, an investor essentially invests in every security within the index in proportion to that security s weight within the index. If Exxon Mobil represents 4.0 percent of the S&P 500 Index, then an indexed portfolio will have a 4.0 percent weight in Exxon Mobil. Strategic Asset Allocation. Asset allocation is one of the most important portfolio management decisions an investment committee can make. Seminal research by Brinson (1986) concluded that over 90 percent of the variability in a pre-tax portfolio s returns is explained by the asset allocation decision, followed by the sector exposure, and lastly individual security selection decisions. Subsequent research by Brinson (1991) found similar results for tax-exempt portfolios regardless of the time period studied. Therefore, in order to achieve your organization s investment objectives, the investment committee should focus on developing the optimal asset allocation. As Brinson s research indicates, once the ideal asset allocation has been determined, the next step is to implement 2012 Campion Asset Management, LLC Page 1
the allocation in a cost effective manner. The decision between active management and indexing is central to the implementation question. While evaluating these two alternatives, the investment committee should take into account research on market efficiency, portfolio performance, and investment management fees. Market Efficiency. Financial research on market efficiency weighs heavily on the ability of active management to outperform indexing to passive benchmarks. Formative research by Fama (1970) suggests that securities markets are efficient in some form and that securities prices fully reflect all available information. Additionally, Graham (1976), notably considered the father of security analysis, proclaimed: In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I m on the side of the efficient market school of thought now generally accepted by professors. With the volume and speed of information via the Internet, today s security prices reflect all available information almost instantaneously. This makes the odds of active management outperforming indexing almost insurmountable. Performance Measurement and Evaluation. Before you commission an investment manager to select among the thousands of possible investment vehicles, it is worthwhile to study empirical research on the performance of active managers. Malkiel (2005) analyzed the performance of actively managed large-cap equity and fixedincome mutual funds. He found that over a 10-year period, 86 percent of actively managed equity funds underperformed their benchmark, as did 90 percent of actively managed fixedincome bond funds. He further noted that over that same time period actively managed equity mutual funds underperformed the S&P 500 Index on average by 2.70 percent. The main reasons for this persistent underperformance are excessive portfolio turnover and investment management fees. Malkiel found that once portfolio turnover exceeds 100 percent, the probability of underperforming a benchmark approaches 100 percent. The solution to this problem is to index the core of an organization s portfolio. 2012 Campion Asset Management, LLC Page 2
Ellis (2011) had similar findings to Malkiel and explains, In today s intensively competitive security markets, few active managers outperform the market by even 1 percent over the long term, most managers fall short, and in terms of magnitude, underperformance substantially exceeds outperformance. Sharpe (1991) further demonstrates that regardless of the time period studied, it must be the case that gross-of-fee returns on the average actively managed investments will equal gross-of-fee returns on the average passively managed investments. Unfortunately, then the returns of actively managed investments net of fees and all costs must be less than the returns of passively managed investments. For the few active managers that outperform their benchmarks, it is worthwhile to determine whether their performance is really the result of luck or skill. Consider a well- = 0.20 per month) and whose portfolio has 20 percent greater risk than the benchmark (i.e., β = 1.20). Assume that the return distribution of the fund has a constant mean, beta, and risk associated with specific securities in the fund that cannot be diversified away) is 2 percent, consider how long it would take to determine whether the fund manager s performance was the result of luck or skill at a 5 percent confidence internal (i.e Solving for N, one can see that it would over 30 years or an entire career in the investment management profession to distinguish skill from chance. No wonder Malkiel (2004) suggested that a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts. Investment Management Fees. Jensen (1968) first showed that on average active managers consistently underperformed their benchmarks by the amount of their fees. Ellis (2011) succinctly summarizes the body of research on investment management fees as follows: 2012 Campion Asset Management, LLC Page 3
After 50 years of fee increases, overall investment management fees are now greater than the risk-adjusted incremental returns. This means that investment managers now charge clients more than 100 percent of the benefits actually produced. Ennis (2011) further explained that despite all of the research on the inability of active managers to outperform their benchmarks, investment management fees are at an all-time high. Ennis further demonstrated that as investment management fees rise, the level of skill required to have just an even chance of outperforming a benchmark rises inconceivably while the probability of outperforming a benchmark drops precipitously. This finding alone casts serious doubt on the benefits of adding high-fee alternative investments let alone actively managed funds. Conclusion. Ellis (1975, 1985) eloquently compared the performance of active managers trying to beat the market to professional tennis players trying to win the Wimbledon Championship. The key to winning in professional sports is simply to make fewer errors than one s opponent. The key to successful investing is similar. By indexing, the investment committee not only guarantees fewer errors, but it also: Recognizes the importance of the asset allocation decision Acknowledges that securities market are efficient in some form Positions a portfolio to enhance long-term returns Minimizes investment management fees and transactions costs The positive impact of indexing on long-term performance will advance the mission of an organization for decades to come. 2012 Campion Asset Management, LLC Page 4
References Brinson, Gary, L. Randolph Hood and Gil Beebower. 1986. Determinants of Portfolio Performance. Financial Analysts Journal, vol. 42, no. 4: 39 44. Brinson, Gary, Brian Singer, and Gilbert Beebower. 1991. Determinants of Portfolio Performance II: An Update. Financial Analysts Journal, vol. 47, no. 3: 40 48. Carhart, Mark M. 1997. On Persistence in Mutual Fund Performance. Journal of Finance, vol. 52, no.1 (March):57 82. Ellis, Charles. 1975. The Loser s Game. Financial Analysts Journal. Reprinted in Classics: An Investor s Anthology. Charles D. Ellis and James R. Vertin, eds. Homewoood, IL: Business One Irwin:1989. Ellis, Charles. 1985. Investment Policy. Homewood, IL: Dow Jones-Irwin. Ellis, Charles. 2011. The Winner s Game Financial Analysts Journal, vol. 67, no. 4: 11 17. Ennis, Richard, 2011. Are Active Management Fees Too High? Financial Analysts Journal, vol. 61, no. 5 (September/October):44 51. Fama, Eugene F. 1970. Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, vol. 25, no. 2 (May):383 417. Goyal, A., Wahal, S. 2008. The Selection and Termination of Investment Management Firms by Plan Sponsors, Journal of Finance, vol. 63, no.4:1805 1847. Graham, Benjamin, 1976. A Conversation with Benjamin Graham. Financial Analysts Journal, vol. 32, no. 5 (September/October):20 23. Ibbotson, Roger G. and Paul D. Kaplan. 2000. Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Financial Analysts Journal, vol. 56, no. 1: 26 33. Jensen, Michael J. 1968. The Performance of Mutual Funds in the Period 1945 64. Journal of Finance, vol. 23, no. 2 (May):389 416. Malkiel, Burton. 2004. A Random Walk Down Wall Street. New York and London: Norton and Company. Malkiel, Burton. 2005. Presentation to the Washington Society of Investment Analysts: 12 15. Sharpe, William. 1991. The Arithmetic of Active Management Financial Analysts Journal, vol. 47, no. 1: 7 9. Sharpe, William. 1992. Asset Allocation, Management Style and Performance Measurement. Journal of Portfolio Management, vol. 18, no. 2: 7 19. 2012 Campion Asset Management, LLC Page 5