Passive and Active Management: A Balanced PerspectiveBY THOMAS GUARINI, ETF STRATEGIST, GLOBAL ETF STRATEGY & RESEARCH, STATE STREET GLOBAL ADVISORS This paper presents a comprehensive examination and synthesis of the passive versus active argument, providing practitioners with the information to form their own conclusions and make decisions for the benefit of their clients and business. period from January 1, 1996 to December 31, 2010, and the 1-year TABLE OF CONTENTS period from January 1, 2010 to December 31, 2010. The paper also EXECUTIVE SUMMARY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 examines the 2008 market downturn and subsequent recovery. DEFINING PASSIVE AND ACTIVE MANAGEMENT. . . . . . . . . 2 For the 15-year period ended December 31, 2010, the majority of Advantages of Passive Management. . . . . . . . . . . . . . . . . 2 actively managed funds outperformed indexes in just three asset Disadvantages and Risks of Passive Management. . . . . . 2 classes—small cap blend, small cap growth, and international. Advantages of Active Management. . . . . . . . . . . . . . . . . . 3 While active management fared relatively well in these less efficient, Disadvantages and Risks of Active Management. . . . . . . 3 less liquid areas of the market, excess return proved to be much more difficult to obtain for active managers in the nine remaining EVALUATING ACTIVE VERSUS PASSIVE PERFORMANCE . 4 . . categories, particularly in large cap blend, mid cap blend, and fixed Long-Term Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 income where 65% to 85% of active managers underperformed Active Performance in Down Markets. . . . . . . . . . . . . . . . 6 the given benchmark. Short-Term Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Small cap value, mid cap value, international, and fixed income MAKING THE DECISION: PASSIVE VERSUS ACTIVE . . . . . . . 7 active managers fared best for the 1-year period ended December Passive Personality Indicators . . . . . . . . . . . . . . . . . . . . . 8 . . 31, 2010. More often than not, active managers in these categories Active Personality Indicators. . . . . . . . . . . . . . . . . . . . . . . . 8 were able to outperform the benchmark. This was not the case for the eight remaining categories. ETFS AS A PASSIVE INVESTMENT OPTION . . . . . . . . . . . . . . 9 LOOKING AHEAD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Interestingly, more than 80% of active managers in large cap, mid ADDENDUM: An Expanded Look at cap, and small cap blend funds beat their respective Dow Jones Passive and Active Management Theory . . . . . . . . . . . . . . . 11 . . size benchmark over the bear market period of March 2000 through December 2001. It was a different story during the Great Recession. ETF Resources at State Street Global Advisors. . . . . . . . . . . . 12 In late 2008, as correlations converged and nearly all asset classes declined, managers of actively managed mutual funds generally failed to protect on the downside. What’s more, when the market recovery in 2009 provided another opportunity for active managersEXECUTIVE SUMMARY to demonstrate their ability to add value, the majority of activeAcademics and investment experts have debated the merits of managers outperformed a relative index in only four of twelveactive and passive investment management for decades. Similar to categories, a trend that continued into 2010.opposing political parties, the two investment camps see the worldin very different ways. Passive managers contend that they deliver The paper’s lesson is a familiar one: In general, markets tend to bethe greatest return over the long term by owning the market. Active fairly efficient and managers who try to exploit market inefficienciesmanagers assert that their stock picking can beat the market. While through active management often prove to be ineffective. Yet, thescores of academic studies have presented compelling data to paper concludes that active and passive management investmentdocument the advantages of the passive approach to investment styles are not mutually exclusive. In fact, sophisticated investorsmanagement, active managers often counter that they are equipped may benefit from a strategy that employs both passive and activeto add alpha in both up and down markets. Accordingly, the extreme management. Finally, the paper introduces exchange traded fundsand diverging market conditions over the last several years has (ETFs) as a passive investment vehicle that compares favorably topulled the active versus passive debate into much sharper focus. both actively-managed mutual funds as well as index mutual funds —and has applications for investors seeking inexpensive beta fromTo guide investment professionals in evaluating the passive traditional asset classes as well as those looking to add value byand active applications for investment management, this paper investing in a specific market niche, whether it be a particularpresents performance data of actively managed mutual funds sector, country, or region.and corresponding benchmarks by asset class over the 15-year 1www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
–– COMPETITIVE PERFORMANCE Within the context of the efficientDEFINING PASSIVE AND ACTIVE MANAGEMENT market hypothesis, investing becomes a zero-sum game sincePASSIVE MANAGEMENT, also known as index investing, is an markets are efficient and, as a result, fully reflect all relevantinvestment strategy that attempts to replicate the returns of an information. In theory, after adjusting for the impact of costs, theindex or benchmark by owning the same assets, in the same returns of passively managed portfolios should be higher thanproportions, as the underlying index. Passive investing does most active portfolios. Nobel laureate William Sharpe illustratesnot seek to capture any excess returns, but rather to match the this most succinctly in his 1991 article, “The Arithmetic of Activeperformance of the index. Indexed Mutual Funds and ETFs are Management”:common vehicles used for passive investing. “f active and passive management are defined in sensible IPassive management rests on the assumption of market efficiency ways, it must be the case that:and a concept called the Efficient Market Hypothesis (EMH).Developed by Eugene Fama in1965, EMH is a cornerstone to 1. efore costs, the return on the average actively Bthe passive versus active debate because it contends that stocks managed dollar will equal the return on the averagewill always trade at a fair value price that reflects all available passively managed dollar; andinformation at that time, thus no one stock can be deemed over-or undervalued at a given point. Modern Portfolio Theory (MPT) is 2. fter costs, the return on the average actively managed Aprimarily based on the EMH concept. dollar will be less than the return on the average passively managed dollar.ACTIVE MANAGEMENT, in contrast to passive management, is aninvestment strategy where managers attempt to add value over These assertions hold for any time period. Moreover,the returns of an index by picking stocks based on models, insights, they solely depend on the laws of addition, subtraction,and analytical research. Unlike passive managers, active managers multiplication and division. 1 ”will not seek to match the risk and return profile of an index. They In theory, indexed portfolios should deliver higher risk-adjustedbelieve that markets are inefficient and, therefore, stocks are often returns (returns adjusted for volatility). Passive managementmispriced. Active managers will try to identify those stocks and should potentially reduce the risk of manager underperformanceexploit pricing inefficiencies to obtain excess return. over longer time horizons. In fact, much empirical evidence and academic research supports the notion that it is nearly impossibleFor a more detailed review of passive and active management to beat a market portfolio over time after accounting for fees,principles and theoretical foundations, please reference the costs, capital gains and taxes.Addendum found at the end of this paper.ADVANTAGES OF PASSIVE MANAGEMENT DISADVANTAGES AND RISKS OF PASSIVE MANAGEMENTPassive portfolios, or indexed portfolios, are market-driven, not While its advantages are compelling, there may also be somemanager-driven. Their broad, diversified exposure to the market, potential disadvantages to passive management.delivers the following benefits: –– MARKET RETURNS ONLY Indexing is not about timing the market or–– DIVERSIFIED, RISK-CONTROLLED EXPOSURE Passive portfolios, or hand-picking stocks. Rather, it seeks to generate market returns indexed portfolios, are market-driven and not manager-driven. and does not seek to “beat” a benchmark. Investors in search As such, they generally deliver broad, diversified exposure to the of—and who believe they can achieve—better-than-market market and can effectively eliminate style drift or capitalization returns will not realize those excess returns utilizing a passive “bets” as requested by the investor or client. investment approach.–– LOWER EXPENSES AND IMPROVED TAX EFFICIENCY Index portfolios –– NO ABILITY TO DEFEND AGAINST DOWN MARKETS A second potential are usually less expensive to maintain than active funds. disadvantage to a passive approach is its inability to provide Conventional wisdom implies that the cost of managing an defensive measures during market downturns. Indexes offer index fund should be significantly less than that of managing an purity, and therefore, when markets are up, indexes take full active fund. Since passive portfolios do not require managers advantage of the benefits. However, when markets decline, to expend resources researching the market or selecting indexes have no reprieve from the fall. stocks, passive management should be less costly than active management. Because passively managed investments track a market index, such funds usually enjoy relatively low portfolio turnover. Because low turnover decreases transactions, transaction costs are also decreased. Additionally, low turnover generates less capital gains and lower tax costs. As a result, indexing can be inherently tax-efficient. 2www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
ADVANTAGES OF ACTIVE MANAGEMENT met. This reduces the number of transactions that take place inThere are two primary advantages that often prompt investors to the open market, which generally results in lower fees and greaterpursue an active, manager-driven investment strategy: tax efficiency for the investor. Active portfolios will buy and sell stocks more frequently as they assess and reassess the value of–– POTENTIAL TO BEAT THE MARKET Active management proponents each stock they hold. This high relative turnover will require the argue that pricing inefficiencies can be exploited by highly skilled active manager to spend much more on transaction costs. managers. By taking active “bets” relative to the benchmark, or by assuming more risk, active management contends that A closer look at the average fees of active and passive managers investors have the potential to realize excess returns relative to help demonstrate this point. Figure 1 provides the average fees for market returns. active and passive managers, including exchange traded funds, by asset class. Average fees for active management are significantly–– POTENTIAL FOR PROTECTION IN DOWN MARKETS In theory, active higher in most asset classes when compared to their passive management potentially provides protection in down markets. counterparts. For instance, if an investor were to use active Unlike indexed portfolios, which have no discretion to adjust management for the large cap blend portion of their portfolio, they cash reserves to serve as a cushion in declining markets, active would need to outperform by at least 0.67% to compensate for proponents suggest that an actively managed fund could hold the additional fees charged by active managers in this space. more cash reserves, defensively positioning a portfolio to serve as a buoy in bear markets. The evolution of ETFs has made passive investing even more cost effective. In fact, ETFs offer a significant fee advantage in Active management proponents also believe that highly skilled virtually every asset class, most notably in the small cap growth active managers can successfully predict market downturns. space. Small cap growth ETFs cost just 0.33% on average, while This assumption is founded upon the claim that the downside their active mutual fund counterparts charge an average of more protection active management potentially delivers will than four times that amount at 1.57%. This creates a significant compensate for any underperformance in rising markets. expense hurdle rate of 1.24% annually in this space.DISADVANTAGES AND RISKS OF ACTIVE MANAGEMENT At the very least, this relative outperformance hurdle rate wouldWhile its advantages are obvious, the disadvantages of active need to be achieved to substantiate the argument for usingmanagement are less visible. active management in any given asset class. This, of course, is before any consideration is given to the potential additional costs–– HIGHER COSTS AND FEES If we accept the assumptions presented of higher portfolio turnover, capital gains, and taxes. in Sharpe’s article on the arithmetic of active management, then we must acknowledge that, in order to beat or simply break –– RISK AND UNPREDICTABILITY Active management requires that even with a passive strategy, actively managed portfolios must investors have complete confidence in their ability to hire the create enough added value to offset the higher fees and costs right manager who has the skill and ability to consistently associated with this management style. outperform the market over time. Some studies suggest that most managers do not outperform the market and that any Some of the cost differential is a result of the higher turnover rate short-term outperformance has typically been unsustainable. associated with the maintenance of active portfolios. Passive This may give investors additional cause to carefully consider portfolios simply replicate the index and therefore buy or sell utilizing passive management for at least some portion of their securities only when the index changes or redemptions must be investment dollars.FIGURE 1: AVERAGE EXPENSE RATIOS: ACTIVE MUTUAL FUNDS, INDEX MUTUAL FUNDS AND ETFS 2.00% 1.82 1.75% 1.57 1.47 1.39 1.50 1.51 1.43 1.52 1.46AVERAGE NET EXPENSE RATIO (%) 1.50% 1.36 1.38 1.29 1.29 1.31 1.16 1.25% 1.01 0.91 0.89 0.97 1.00% 0.69 0.74 0.76 0.68 0.68 0.75% 0.46 0.44 0.45 0.47 0.41 0.47 0.41 0.42 0.50 0.50% 0.37 0.33 0.23 0.25% 0.00% Large Cap Large Cap Large Cap Mid Cap Mid Cap Mid Cap Small Cap Small Cap Small Cap Fixed Inter- Emerging Blend Growth Value Blend Growth Value Blend Growth Value Income national Markets ACTIVE FUNDS PASSIVE FUNDS ETFSSource: Morningstar Direct, SSgA Global ETF Strategy & Research, as of 12/31/2010.Average Net Expense Ratio for Active Funds, Passive Index Funds, and Exchange Traded Funds by size and style categories. 3www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
EVALUATING PASSIVE VERSUS ACTIVE PERFORMANCE indexes in only three less-efficient, less-liquid asset classes—smallWhile the theoretical case for passive and active investing is fairly cap blend, small cap growth, and international (Figure 2).straightforward, the actual performance of passive versus activevaries greatly by asset class and time period. However, some Most strikingly, over the past 15 years, less than 15% of activepatterns emerge. fixed income managers added value over the corresponding benchmark. For large cap value, blend and growth managers, onlyHistorical evidence suggests, for example, that, on average, active 35 to 43% of funds outperformed. Mid cap funds also struggled;management may not add value—especially within the broader only 24% of mid cap blend funds and 35% of mid cap value fundsasset classes. Research conducted in the 1960s by Jensen (1968), added value. Actively managed mid cap growth funds fared slightlySharpe (1966) and Treynor (1965) found that, on average, active better, with 41% outperforming.funds underperform their benchmarks on a risk-adjusted basisand that the magnitude of underperformance directly relates to It was only in the small cap and international categories thatthe level of expenses.2 Notably, this level of underperformance actively managed funds demonstrated their ability to generatereported in the 1960s and as presented in this study may be excess returns. Although just 39% of small cap value fundsunderstated as a result of “survivorship bias” whereby funds that outperformed, a more impressive 54% of small cap blend fundspreviously merged or no longer exist due to poor performance and 59% of small cap growth funds outperformed.could not be counted. Later research conducted from 1970 to 1990that made adjustments for survivorship bias and risk exposures International equities, generally considered a less efficient assetalso concluded that the average active fund fails to add value class and, therefore, one in which active managers stress theirrelative to its passive benchmark.3 ability to add value, also delivered mixed results. For developed market international equities, 65% of the funds outperformed theLONG-TERM RESULTS index. And while 42% of emerging market funds outperformed,Research conducted by State Street Global Advisors and SPDR® the sample size was small as only 50 emerging market mutualETFs for the 15-year period ended December 31, 2010 found that funds had a 15-year record.more than half of actively managed funds outperformed relativeFIGURE 2: PERCENT OF ACTIVE MANAGERS OUTPERFORMING WITH AVERAGE EXCESS RETURN FOR OUTPERFORMING FUNDS—15 YEAR ANNUALIZED PERIODLarge Cap Blend 34.6 1.4Large Cap Growth 43.0 1.6Large Cap Value 34.7 1.0Mid Cap Blend 24.2 1.7Mid Cap Growth 41.0 1.9Mid Cap Value 35.0 1.0Small Cap Blend 54.1 1.9Small Cap Growth 59.1 2.3 38.5Small Cap Value 1.1 64.5International 2.1 42.0Emerging Markets 1.4 14.9Fixed Income 1.1 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% % OUTPERFORM % ALPHASource: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010.Based on Morningstar data for the past 15 years, ending 12/31/2010. Chart shows the percent of active strategies that outperform the corresponding benchmark by category. Mutual fundperformance is net of fees; index performance is gross of fees. The following indexes were used as benchmarks: Barclays Capital Aggregate Bond Index for Fixed Income, Dow Jones U.S. TotalStock Market Indexes for the respective domestic equities, the MSCI EAFE Index for international equities and the MSCI Emerging Markets Index for emerging market equities. For illustrativepurposes only. Past performance is not indicative of future results. 4www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
Also of note is the magnitude of outperformance for those funds FIGURE 3: LARGE CAP BLEND FUNDS—PERCENT OF ACTIVEthat did generate excess returns. For example, the outperforming MANAGERS OUTPERFORMING (1995 – 2010)large cap value funds added 95 basis points, or 0.95%, on average. 100%The 24% of mid-cap blend funds that outperformed added 1.7% 90% 86.6on average over the index. The 59% of small cap growth funds PERCENTAGE OF OUTPERFORMERS (%)that outperformed added, on average, 2.3%. In general, when 80% 69.6progressing from large cap to small cap, and value to growth, 70%the percentage of outperforming funds and their average excess 60% 54.7return increased. Across international equities, outperforming 51.8 51.2 47.2funds added 2.1% on average in developed markets and 1.4% in 50% 40.6 37.6 39.4 39.7 36.9emerging markets. 40% 27.6 30%Evaluating whether outperformance will persist requires determining 18.5 15.3 18.8the factors that contribute to outperformance. In other words, 20%does outperformance result from skill or luck? After adjusting for 10%factor exposures to control for risk-taking and survivorship bias, 0% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010studies found that repeated positive performance compares to thetoss of a coin—with a probability of approximately 50%. It would Source: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010.seem, then, that luck has as much to do with outperformance as Based on Morningstar data for the past 15 years on a year by year basis, ending Decembermanager skill. 31, 2010. Chart shows the percent of active strategies that outperform the Dow Jones Large Cap U.S. Total Stock Market Index. Mutual fund performance is net of fees; index performance is gross of fees. The following index was used as a benchmark: Dow Jones U.S. Total StockConsider the 15-year results in Figure 2—nearly 35% of active Market Large Cap Index. For illustrative purposes only. Past performance is not indicative oflarge cap blend managers outperformed over that time period. Yet, future results.on a year-by-year basis (Figure 3), the results vary considerably,ranging from as few as 15% to as many as 87% outperforming the outperformed by as much as 7.4% and underperformed by as muchDow Jones Large Cap U.S. Total Stock Market Index. From 1996- as 9.4%. From 1996 to 1999, the median active fund underperformed1999, active funds consistently underperformed—fewer than 20% the index by between 1.7% (1996) and 9.4% (1998). From 2000 tooutperformed in 1997 and 1998. In 2000 and 2001, the trend reversed 2002, the median active large cap fund added between 1.3% (2002)and, respectively, 87% and 70% of active funds outperformed. In and 7.4% (2000) over the index. In the following eight years, thethe following nine years, the percentage of funds outperforming results were mixed as the median active fund underperformed byranged from a high of 55% (2009) to a low of 19% (2010). as much as 1.4% (2010) and outperformed by 1.7% (2009). Predictably, index mutual funds generally underperformed theThe amount of excess return varied considerably as well, following index by approximately the amount of their expenses—0.5% toa similar pattern to the percentage of outperformers (Figure 4). 0.6% on average.Over the entire 15-year period, the median active large cap fundFIGURE 4: ANNUAL EXCESS RETURNS FOR MEDIAN LARGE CAP BLEND FUNDS (ACTIVE AND PASSIVE) 8% 7.4 6% 4%ANNUAL EXCESS RETURN (%) 1.5 1.3 1.5 1.7 2% 0.6 0.1 0% -0.7 -0.7 -0.5 -0.7 -0.5 -0.4 -0.4 -0.6 -0.7 -0.5 -0.5 -0.5 -0.5 -0.3 -0.3 -0.5 -0.7 -2% -1.7 -1.2 -1.4 -2.6 -4% -4.9 -6% -8% -9.4 -10% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 ACTIVE FUND EXCESS RETURNS INDEX FUND EXCESS RETURNSSource: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010.Median Annual Performance of Active and Passive Large Cap Blend funds versus the S&P 500 Index. Mutual fund performance is net of fees; index performance is gross of fees. 5www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
Another way to view the consistency of active manager returns is funds outperformed the index. Tracking this same group of fundsto track the subsequent performance of a group of outperforming over the following five years demonstrates how difficult it is forfunds, as seen in Figure 5. In 2005, 50.8% of active large blend active funds to maintain their outperformance. Only 18.1% of themutual funds outperformed the Dow Jones Large Cap U.S. Total funds were able to outperform in both 2005 and 2006. The resultsStock Market Index by an average of 2.9%. This group of 552 funds then drop dramatically, with only 9.5% outperforming for threeprovided mixed results in the subsequent five years—outperforming consecutive years, 2.5% for four consecutive years and 1.1% for fivein two years and underperforming in three. On average, this group consecutive years. From this original group of greater than 1,000of managers underperformed the index by 0.41% over the following managers, only five outperformed every year from 2005 to 2010.five-year period. Looking deeper into the outperformance of active funds, a researchFIGURE 5: AVERAGE SUBSEQUENT EXCESS RETURNS OF LARGE study published by Russ Wermers in April 2003, “Are MutualCAP BLEND FUNDS THAT OUTPERFORMED IN 2005 Fund Shareholders Compensated for Active Management Bets,” concluded that active management does provide value but that 5% the value is reflected in only a minority of funds that take relatively 4% large volatility bets. The study found that funds taking large bets 3% 2.9 away from the market, or style portfolios, generally performed well 1.9 during simultaneous time periods.4 While the study results cast a 2% somewhat positive light on some active managers, the results also EXCESS RETURN (%) 1% 0.7 indicated a higher potential of underperformance of funds taking higher levels of risk. 0% -1% Returning to the 15-year performance chart (Figure 2) clearly -0.7 illustrates the probability that active managers can add the most -2% -1.7 value in less-efficient, less-liquid areas of the markets, including -2.3 -3% small cap and international stocks. Making active bets in small cap 2005 2006 2007 2008 2009 2010 stocks, and more specifically small cap growth stocks, provides for aSource: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010. higher relative probability of success since more than 59% of smallAverage outperformance of Large Cap Blend Universe for year 2005, subsequent performance cap growth funds beat their corresponding index by an averagefor the same group of managers by year. Outperformance is relative to the Dow Jones Large excess return of 2.3%. Developed international funds offer anCap U.S. Total Stock Market Index. Members of the Morningstar Large Cap Blend Activeuniverse include non index funds in the Morningstar US Large Blend category. Mutual fund increased probability of outperformance, with 65% of activeperformance is net of fees; index performance is gross of fees. managers outperforming, offering an average alpha of 2.1%. ACTIVE PERFORMANCE IN DOWN MARKETSFIGURE 6: PERCENTAGE OF FUNDS OUTPERFORMING IN One of the potential benefits of active management is the abilityCONSECUTIVE YEARS to defend against down markets. Analysis of active large cap, 20% mid cap, and small cap blend funds over the bear market period 18.1 of March 2000 through December 2001, revealed that more than 80% of active managers in each of these three categories beatPERCENTAGE OF OUTPERFORMING FUNDS (%) 15% their respective Dow Jones size benchmark. Eighty-one percent of active large cap blend funds outperformed, providing average excess return of 7.5%. Eighty-two percent of mid cap funds 9.5 10% outperformed, providing 12.1% of excess return, and 87% of active small cap blend managers outperformed while providing an impressive 18.7% in average alpha. Again, the less efficient asset 5% class produces the highest probability of outperformance and the 2.5 highest average excess return. 1.1 0.5 0% 2005-2006 2005-2007 2005-2008 2005-2009 2005-2010 Analysis of a more extensive time period—the 10- year period from 1996 to December 2006—again reveals greater active outperformanceSource: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010. in less efficient asset classes. Active international stock fundsAverage outperformance of Large Cap Blend Universe for year 2005, subsequent outperformancefor the same group of managers by given time periods. Outperformance is relative to the Dow returned an annualized average return of 8.76%, topping the 8.06%Jones Large Cap U.S. Total Stock Market Index. Members of the Morningstar Large Cap Blend return of the Morgan Stanley Capital International Europe, Australasia,Active universe include non index funds in the Morningstar US Large Blend category. Mutual and the Far East Index (MSCI EAFE). The 10-year return for activefund performance is net of fees; index performance is gross of fees. small cap core funds averaged 10.65%, again topping the 9.44%Performance data varied even more considerably when the time return of the Russell 2000® Index. The average return of activeframe was extended to measure outperformance in consecutive emerging markets funds over that same 10-year period at 10.29%years (Figure 6). Again, in 2005, approximately 51% of large cap blend bested the MSCI Emerging Markets Index (MSCI EM), which delivered an annualized return of 9.40%.5 6www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
Based on these statistics and as evidenced in other studies, empirical Extremes in underperformance also existed in 2009. Managersevidence supports the notion that active funds can sometimes that underperformed the index realized much deeper levels ofoutperform passive funds in less efficient markets over certain down under performance on average. In 2010, the average undermarket periods and sustained time horizons. performance of large cap blend funds that did not beat the index was -3.5%. In 2009, this average underperformance wasAnalysis from our most recent down market period—December substantially lower at -5.2%.2007 to February 2009—yielded different results. Fifty-one percentof active large cap blend funds outperformed and provided average While the degree to which over and under performance has variedexcess return of 3.4%. Fifty-seven percent of mid cap blend funds substantially over the past two years, one historical constant hasoutperformed with 5.6% of excess return, and 65% of active small been relative average alpha when comparing categories. Notcap blend managers outperformed while resulting in an average surprisingly, average under and over performance of small cap andalpha of 4.9%. international funds have been more extreme on a relative basis when compared to other asset classes.SHORT-TERM RESULTSRelatively stable market conditions prevailed in 2010. The market MAKING THE DECISION: PASSIVE VERSUS ACTIVEvolatility of 2008 and 2009 gave way to a more tempered extension Statistics presented here and evidenced in other studies supportof the recovery that existed in 2009. However, the ability for active the notion that active funds can sometimes outperform passivemanagers to outperform the market continued to be weak. In 2010, funds in less efficient markets over certain down market periodsactive managers outperformed in just four categories: fixed income, and sustained time horizons. Yet, there is no question that futuremid cap, small cap value and international (Figure 7). Large cap funds theoretical and empirical research on the passive versus activelagged dramatically in 2010 which is in line with historical trends. argument will continue to fuel the passionate debate. Investors who continue to seek out and digest this abundance of informationIn 2009, extremes in manager excess return were pronounced. should be wary of any expectation that they will be led to aFunds that did outperform tended to do so by a much wider margin definitive conclusion as to which approach is best. As articulatedthan in years past. This was generally not the case in 2010 as in this analysis, compelling arguments can be—and will continueexcess return results tended to fall into a more familiar pattern. For to be made—for both management approaches. Rather thaninstance, in 2009, 55% of large cap blend funds outperformed the ask whether passive or active management is better, the moreDow Jones Large Cap U.S. Total Stock Market Index. This group of fundamental question advisors must address is: How can I helpfunds outperformed the index by 670 basis points on average. In clients make the best decisions with respect to which approach2010, a less extreme 19% of large blend funds outperformed by an most appropriately pursues their individual goals and objectives?average of 330 basis points.FIGURE 7: PERCENT OF ACTIVE MANAGERS OUTPERFORMING IN 2010Large Cap Blend 18.8 3.3Large Cap Growth 33.8 3.3Large Cap Value 25.4 2.4Mid Cap Blend 23.0 2.2Mid Cap Growth 25.4 3.1Mid Cap Value 53.3 3.0 17.7Small Cap Blend 4.2 22.0Small Cap Growth 2.8 62.4Small Cap Value 3.9 77.0International 4.6 42.0Emerging Markets 4.3 52.2Fixed Income 2.8 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% % OUTPERFORM % ALPHASource: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010.Based on Morningstar data for the year 2010. Chart shows the percent of active strategies that outperform the corresponding benchmark by category. Mutual fund performance is net of fees;index performance is gross of fees. The following indexes were used as benchmarks: Barclays Capital Aggregate Bond Index for Fixed Income, Dow Jones U.S. Total Stock Market Indexes for therespective domestic equities, the MSCI EAFE Index for international equities and the MSCI Emerging Markets Index for emerging market equities. For illustrative purposes only. Past performance isnot indicative of future results. PA2 7www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
The decision to employ active or passive management should FIGURE 8: PASSIVE VERSUS ACTIVE DECISION TREEbe made by the advisor in the context of an investor’s overallinvestment objectives and their ability to tolerate risk. In making QUESTION 1 INVESTthe active/passive decision, there are several questions advisors Do you believe that markets are generally inefficient? NO PASSIVELYand their clients should carefully consider: YES1. What is your tolerance for underperformance? QUESTION 2 INVEST2. How comfortable are you with taking on active risk? Do you believe that there are some managers who NO PASSIVELY can consistently beat the benchmark?3. Do you believe markets are more likely to behave efficiently or inefficiently? YES4. Do you believe skill-based managers can add value? QUESTION 3 INVEST NO Do you believe that you can find those managers? PASSIVELY5. How confident are you in your ability to select the top- performing active managers? YESThe answers to the questions above could help guide investors inmaking the active/passive decision. Additional indicators investors INVEST ACTIVELYmight use as guidelines to determine which approach best suitstheir individual needs appear below. Some investors, when considering the questions and guidelinesPASSIVE PERSONALITY INDICATORS presented here, may find that they and their beliefs do not neatly–– Believe markets are efficient fit into one category or the other, but rather lie somewhere–– Unwilling to tolerate a high level of active risk or variance in in between. Sophisticated advisors and investors, upon close return potential vs. the benchmark examination of the rationales for passive and active management, may find themselves fluctuating between the two. Does a middle–– Believe performance of individual asset classes and styles is ground exist? Is a compromise between active and passive unpredictable management possible?ACTIVE PERSONALITY INDICATORS Given the results presented in this paper, it may make sense to–– Believe markets are inefficient and assets are priced above or allocate a greater portion of one’s risk budget to those areas where below fair market value the opportunities to add value are statistically probable. It stands–– Believe skilled managers are able to identify mispriced assets in to reason that passive strategies should be relied upon when the advance potential to beat the market is relatively poor. That is, employ–– Able to identify skilled managers in advance active managers in asset classes where the manager has a greater chance of outperforming, and utilize passive for those market–– Willing to assume higher level of risk and variance in return segments deemed to be efficient. potential When employing active management within a portfolio, it is againAnother helpful approach to assessing your (and your client’s) important to note the considerations that should be taken withinvestment personality is outlined in Figure 8. Ask yourself each respect to excess fees and tax liabilities that often accompanyof the questions in sequence; your answer will determine your these strategies. After having accounted for a wide variety ofinclinations toward active or passive investing. preferences and objectives, investors should decide at which point and in what space it makes sense to utilize active management. 8www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
ETFs as a Passive Investment OptionWhen choosing index funds for their significant advantages relative average ETF capital gain distribution has historically only been ato actively managed funds, it is important to recognize that there fraction of the average capital gain distribution for a mutual fund.is considerable variability within index funds in terms of expenseratios, ability to track the index, and tax efficiency. In many cases, TABLE 2: AVERAGE CAPITAL GAINS DISTRIBUTION OF ETFS VS MUTUALETFs can be the most attractive index choice. ETFs generally offer FUNDS AVERAGE MUTUAL FUND CAPITAL AVERAGE ETF CAPITAL GAINa fee advantage—not just over actively managed mutual funds, but GAIN DISTRIBUTION DISTRIBUTIONalso over index mutual funds (Table 1). 2000 1.79 0.13TABLE 1: ETF EXPENSE ADVANTAGE 2001 0.33 0.02 INDEX MUTUAL FUND AVERAGE ETF AVERAGE ETF EXPENSE 2002 0.11 0.00 ASSET CLASS EXPENSE RATIO EXPENSE RATIO ADVANTAGE 2003 0.13 0.01 SMALL CAP VALUE 1.43 0.41 1.02 2004 0.45 0.03 SMALL CAP GROWTH 1.31 0.33 0.98 2005 0.76 0.05 MID CAP VALUE 1.29 0.41 0.88 2006 1.03 0.04 MID CAP GROWTH 1.16 0.47 0.69 2007 1.48 0.08 LARGE CAP GROWTH 1.01 0.44 0.57 2008 0.32 0.00 LARGE CAP VALUE 0.91 0.37 0.54 2009 0.04 0.04 SMALL CAP BLEND 0.89 0.47 0.42 2010 0.12 0.06 MID CAP BLEND 0.74 0.45 0.29 Source: SSgA Global ETF Strategy & Research. Based on Lipper data as of 12/31/2010. INTERNATIONAL 0.76 0.50 0.25 Past performance is not indicative of future results. ETF Capital Gains are exclusive LARGE CAP BLEND 0.69 0.46 0.23 of inverse and leveraged products. FIXED INCOME 0.42 0.23 0.19 ETFs also offer potential tax advantages relative to other types of EMERGING MARKETS 0.68 0.68 0.00 index funds. Table 3 shows the average capital gain distribution for the Source: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010. SPDR S&P 500® ETF (SPY) relative to the average S&P 500 Index Morningstar Average Net Expense Ratio for Index Mutual Funds, and Exchange Traded Funds fund. Over the analysis’ 5-year period, SPY had no distributions, by size and style categories. versus 0.36% for the average S&P 500 Index mutual fund.In addition to any expense and performance advantages, ETFs TABLE 3: CAPITAL GAINS DISTRIBUTIONS AS A PERCENTAGE OF NAV*have also proven to be relatively tax-efficient. Traditional mutual SPDR S&P 500 ETF (SPY) AVERAGE OPEN END S&P 500 INDEX FUND**funds are required to pass any realized capital gains on toinvestors as a capital gains distribution. These realized capital 2005 0.00 0.24gains could be the result of portfolio turnover related to portfolio 2006 0.00 0.43manager decisions. Capital gains can also be realized due to fundredemptions, when the portfolio manager must sell securities 2007 0.00 1.21to raise cash for redemptions. This distribution is taxable to the 2008 0.00 0.14investor regardless of how long he or she held onto the fund 2009 0.00 0.10shares (the decisive factor is the record date for the distribution). 2010 0.00 0.03Capital gains distributions for ETFs have historically been AVERAGE 0.00 0.36substantially lower than for mutual funds (Table 2). This is due to CUMULATIVE 0.00 2.51the way ETFs are structured. For most investors, ETFs are boughtand sold on the secondary market. As a result, unlike a traditional Source: Bloomberg, Morningstar, MSSB Research, as of 12/31/2010. * Year End NAV.mutual fund, when an investor sells ETF shares, there is no **Average open-end S&P 500 fund. Does not include funds that liquidated.impact to the portfolio and the portfolio manager is not requiredto sell securities to raise cash for the redemption. For very large ETFs now enable investors to reach every corner of the global market.purchases and redemptions, there will be a creation or redemption In addition to functioning as a cost-efficient, passive investment inof ETF shares as a basket trade with the ETF’s market makers. traditional core asset classes, ETFs can also serve as low-cost satelliteThis is considered an in-kind transaction. Such transactions are plays to express particular sector or geographical bets wherenot subject to capital gains taxes. As you can see in Table 2, the investors believe managers could outperform. 9www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
LOOKING AHEAD active management. We believe this paper illustrates that bothAssets invested in index investments, including mutual funds approaches have their merits. The benefits of passive investingand ETFs, are on the increase. Although active funds continue include reduced costs and tax efficiency—and, historically, passiveto dominate market share (76.5% of mutual fund assets were funds have outperformed a majority of active funds over long timeinvested in active funds at the end of 2010), over the last nine horizons. However, active funds often outperform in less efficientyears, active managers have consistently lost market share markets and active management proponents stress that there areto their passively managed counterparts. Given that actively always market anomalies that can potentially be exploited by activemanaged funds failed to protect during the Great Recession managers.and today’s investors continue to reassess their risk tolerance,it’s likely the trend toward passive investing will continue. Apart from what will be an ongoing debate, when constructing a portfolio, advisors must work with their clients to discover personalAs articulated in this analysis, compelling arguments can be risk tolerance levels to craft an investment solution that best meetsmade—and will continue to be made—for both investment their needs. In today’s transitioning market, for many clients theapproaches. Amid this ever-widening sea of information and best approach may be a sophisticated solution that leverages bothpotential misinformation, it is important that advisors provide passive and active management. In this way, investors can look toguidance and direction to help their clients understand the key incorporate the best that each strategy has to offer.distinctions, advantages and disadvantages of both passive andFIGURE 9: INDEX FUNDS’ MARKET SHARE CONTINUES TO RISEPERCENT OF FUND ASSETS FOR ACTIVE FUNDS, INDEX FUNDS AND ETFS 1.5 3.2 3.5 4.5 5.3 6.0 7.3 9.5 10.2 11.2 100% 9.8 9.3 9.6PERCENTAGE OF OUTPERFORMING FUNDS (%) 10.5 10.5 10.6 10.7 11.1 11.3 12.3 80% 88.7 87.5 86.8 85.0 84.3 83.5 82.0 79.4 78.5 76.5 60% 40% 20% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 % IN ACTIVE FUNDS % IN INDEX FUNDS % IN ETFSSource: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010. Data is US open-end mutual funds and ETFs as defined by Morningstar. Mutual Funds used are exclusive ofmoney market funds and fund of funds. 10www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
ADDENDUMAn Expanded Look at Passive and Active Management TheoryWHAT IS PASSIVE MANAGEMENT? WHAT IS AN INDEX?First, what is meant by “passive?” Passive management rests An index tracks a group of investments that are representative ofon the assumption of market efficiency, a topic upon which the an entire asset class or market, as a way of measuring that assetacademic community has focused exhaustive theoretical and class’ performance. Designed to match market performance, anempirical studies. As understood today, Modern Portfolio Theory indexing strategy invests in the same securities and in the same(MPT) is based primarily on the pioneering research of two Nobel proportions that the market or benchmark index holds. There is noPrize winners, Eugene Fama and Harry Markowitz. aim to outperform or to obtain excess returns.Though it emerged as a concept years earlier, the theory of market Most indexes today are capitalization-weighted as opposed toefficiency was first formalized and supported by empirical evidence price-weighted or equal-weighted. That is, each stock impactsfrom Eugene Fama in 1965, when the Journal of Business published the index in proportion to its market value—the number of sharesFama’s doctoral thesis: “The Behavior of Stock Market Prices.” In outstanding multiplied by the share price. Today, investors canhis thesis, Fama posited the Efficient Market Hypothesis (EMH). choose from literally thousands of index mutual funds and ETFs that track all major asset classes, regions and sectors.Conventional wisdom asserts that individuals or institutions whoinvest in the stock market do so with the aim of generating a return While still not as popular among retail investors as active investmenton the capital invested. In addition to generating profitable returns, strategies, indexing has experienced tremendous growth over themany investors try to outperform a particular benchmark. EMH, past several years, especially with the recent evolution of exchangehowever, suggests that it is impossible to beat the market because, traded products. In the US, these investment vehicles have grownat any given time, prices fully reflect all available information on a from less than $100 billion in assets under management in 2001 toparticular stock and/or market. The nature of the information does more than $500 billion today. What accounts for such tremendousnot have to be limited to financial news and research alone; indeed, growth? The surge may be attributed to wider recognition of theinformation about political, economic and social events, combined potential benefits such an approach can deliver.with how investors perceive such information, whether true orrumored, will be reflected in the stock price. WHAT IS ACTIVE MANAGEMENT? Unlike passive management, active management rests on theThus, according to the theory of market efficiency, no investor has assumption that markets are inefficient. One of the premises uponan advantage in predicting a return on a stock price because no one which this theory is based is the notion that investors are nothas access to information that is not already available to everyone rational beings as Modern Portfolio Theory suggests. In fact, activeelse. Given that prices only respond to information available in the proponents posit that inefficiencies develop as a result of themarket, and all market participants are privy to the same information, irrationality of investors.no one will have the ability to “out-profit” anyone else.6 The existence of financial bubbles and historical anomalies suggestsAs a result, the Efficient Market Hypothesis suggests that investors such inefficiencies may exist. Active management attempts tomay be best served by owning the broad market. Investors can exploit those inefficiencies with the objective of beating the marketuse an expansive market index or a series of specialized indices to on a risk-adjusted basis, as measured by a particular index or passivebuild a portfolio that replicates the market. This investment benchmark. Unlike indexing, which seeks to own all stocks within aapproach, called indexing, is the basis for passive management. particular market, active managers only buy what they perceive as the most attractive stocks and in some cases, sell short perceived unattractive stocks within a particular market. 11www.spdru.com FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR PUBLIC USE.
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