Active versus Passive Management September 13 th, 2015 - LAPERS Darren Fournerat, CFA, CAIA Laney...
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Transcript of Active versus Passive Management September 13 th, 2015 - LAPERS Darren Fournerat, CFA, CAIA Laney...
Active versus Passive ManagementSeptember 13th, 2015 - LAPERSDarren Fournerat, CFA, CAIALaney Sanders, CFA
Agenda
• Defining “Active” and “Passive” for portfolio management
• Different approaches for implementation for each tactic
• Support for each strategy• Current market dynamics• Smart Beta
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Portfolio Management Process
• Strategic or tactical asset allocation decisions– Allocation to a particular asset class
• Implementation– What is the best way to invest in that
asset class?– Use Active or Passive approach?
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Active versus Passive
• Active management seeks to outperform a given benchmark– Overweight or underweight securities relative
to appropriate benchmark in an attempt to “beat the market”
• Passive management simply seeks to gain exposure to a certain market– Does not express investment expectations as
to which securities will outperform within that particular market
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Spectrum of Portfolio Management
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Index Fund
Enhanced Indexing / Semi active
Long Only Benchmark constrained Long / Short Hedge Funds
Passive
Active
Passive Management - Indexing
• An index fund is a portfolio of securities that is purchased, held
and managed in order to match the return and risk
characteristics of an index
– Two types of index funds include:
• Fully Replicated
– An index fund that holds every single security in the
index, and each position will have approximately the
same weight in the fund as in the index
• Optimized
– An index fund that holds a “representative” sample of
securities that is determined by advanced
mathematical programming software6
Passive Management – Indexing
• Indexing is the most prevalent approach to passive investing
• Attempt to match the performance of a pre-specified benchmark
• Began in the 1970s– Quickly grown to where it is today – U.S. alone has
more than $1 trillion in institutional indexed equities
• Despite this growth, active management still accounts for the overwhelming majority of equity assets managed
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Active Management
• Seeking to outperform the market• Types of Active management
– Almost Passive• Enhanced indexing• Smart Beta
– Constrained• Long-only
– Unconstrained• Long-Short hedge fund
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Active Management
• Considerations for hiring active managers– Which benchmark is appropriate?– What constraints will be placed on the
manager to manage risk?• Exposure limits• Pre-defined sub-asset class ranges• Are they allowed to short and / or use leverage?
– What fees do they charge?• Flat management fee? • Performance based fee?
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Support of Passive Management
• After fees, the return of the average actively managed dollar, will be less than the average passively managed dollar*
• Limited evidence that performance persistence exists– Makes consistently selecting top active
managers very difficult
• Time and resources needed for active management
10*Source - The Arithmetic of Active Management” by William Sharpe
Support of Active Management
• Market “anomalies” do exist– Size Effect– Value Effect
• Modern Portfolio theory / Efficient market hypothesis does not consider “behavioral biases”– Traditional theory assumes all investors
act rationally
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Market Efficiency
• An efficient market is one in which asset prices reflect new information rationally and quickly– Less efficient markets usually present
greater opportunities for excess return, or “alpha”
• Market capitalization • Developed versus emerging• Traditional versus alternative
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Opportunities for Outperformance
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Current Market Dynamics
• Strong U.S. equity performance recently has made it difficult for active managers– S&P 500 gained nearly 75% for the
three-year period ending December 31st, 2014
– Index finished in the top quartile of Large Cap domestic active managers
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Current Market Dynamics
• Why have active managers struggled?– Active managers target higher quality
stocks, in general• In the “risk-on” environment created by
quantitative easing in the U.S., lower-quality stocks managed to outpace better-quality stocks for three years
– Active managers keep some cash, or “dry powder,” to be able to quickly execute opportunities as they present themselves
• Cash drag is magnified when returns are high
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Smart Beta – Growth and Popularity
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Smart Beta
• Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes
• Take advantage of perceived systematic biases or inefficiencies in the market– i.e.: size, value, volatility
• Claims to offer market-beating returns with a rules based, simplistic, and low cost approach
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Smart Beta – Growth and Popularity
• Key findings of Invesco’s Evolution of Smart Beta ETFs– 1 in 3 (36%) institutional decision makers indicate they
are currently using Smart Beta ETFs– 64% of institutions indicate they are likely to increase
their use of ETFs over the next three years– Six in ten institutional investors surveyed are now
familiar with smart beta ETFs, up from 54% last year– Nearly two-thirds of institutional decision makers
expect to increase their use of smart beta ETFs over the next three years
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Smart Beta – What is holding it back?
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How “Smart” is Smart Beta?
• Smart Beta portfolios are not really passive– Actively betting on certain “factors” to outperform– Decision to not hold cap-weighted index – Must decide weighting and rebalancing rules
• Vulnerable to being replicated, overcrowded, and are prime targets for front-running– Most of the common factors are already known by the
markets– More transparent than active strategies
• Given the same universe, smart beta strategies are not diversifying to traditional cap-weighted indices
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Wrapping up: Active or Passive
• Things to consider:– Market efficiency
• Less efficient markets can present an opportunity for active management to outperform
– Risk tolerance• Active management will expose you to
some level of tracking error (active risk)
– Fee tolerance• The more active the strategy, the higher the
fees
– Staff resources• Hiring and overseeing active managers
takes time
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