Active vs. Passive Money ManagementExploring the costs and benefits of two alternativeinvestment approachesBy Baird’s Advisory Services ResearchSynopsisProponents of active and passive investment management styles havemade exhaustive and valid arguments for and against both approaches.Each has its merits and inherent drawbacks, and this paper will notendorse one style over the other. Rather, our goal is to define thecharacteristics of each approach in an effort to help you determinewhich best suits your needs and preferences.Investors encounter different opportunities and challenges at differenttimes, which can help determine the investment management approachthat is the best for them. On one hand, we believe active managementcan add value when coupled with strict due diligence services. On theother hand, when limited investment options are available or the best youcan do is “average” performance, passive investment options may makemore sense due to fees and other considerations. Regardless, a clearerunderstanding of how to balance and leverage both active and passivemanagement is crucial to realizing your investment objectives.The Basics of Active and Passive ManagementThe proliferation of passive management strategies in recent years is welldocumented and evidenced by the exponential growth of the ExchangeTraded Fund (ETF) marketplace. Currently there are more than 800ETFs available; many of these employ passive strategies and range fromthose replicating the widely-recognized S&P 500 Index to more nicheindexes such as the S&P Global Water Index. Passive management hasproven a viable strategy and is challenging the more traditional portfolioconstruction practice of investing strictly in active managers.
Several factors should be considered As Table 1 shows, there are tradeoffs when deciding between active and between the costs and potential passive management. These factors vary benefits of the two approaches. Passive greatly from one client to another and management will maintain exposure the solutions can be just as unique, to the market, but not offer any ranging from a purely passive to purely potential for above-benchmark returns active approach or some combination (or down market protection). Active of both. The correct use of these management offers the potential for strategies can help build a portfolio above-market returns, but comes with better suited to your specific needs. the chance that the manager won’t beat the stated benchmark. Also, Active vs. Passive Management Defined neither approach can completely shelter you from the possibility of The difference between active and below-market returns. These variables passive investment management and the nuances of your specific lies primarily in the stated goal situation make this a decision best and the approach used to reach it. made with the assistance of your Active management is overseen by Financial Advisor. The remainder investment professionals striving to of this paper should help guide you outperform specific benchmarks. through that decision-making process Passive management (i.e., index ETFs, by offering examples of when, where, index funds) attempts to replicate and how Baird believes active or the return pattern of a specific passive strategies should be used. benchmark. With active management, investment experts are hired based Implementation of Active on the perceived value they can add and Passive Strategies above and beyond the benchmark. Passive management often stresses low Proceeding from the conclusion that costs, tax efficiency and the concept of both active and passive management market efficiency. are valid strategies, the questionTABLE 1: becomes where and when is one more appropriate than the other? The Passive Management Key Feature Active Management following pages will outline several Generally lower than active Investment Generally higher than common considerations. management Management Fees passive management Depends on the The Truth of Market Efficiency Generally tax efficient Tax Efficiency investment manager Market efficiency is the degree to Potential for which stock prices reflect all available No Yes Above-Market Returns information. In a perfectly efficient Potential for Yes, after incorporating fees Yes market, all stocks are precisely valued Below-Market Returns Potential for and no active manager has the ability No Yes Down Market Protection to outperform the market. If the Seeks to replicate the Seeks to capitalize on market were completely inefficient, Decision Making Process performance of the benchmark market conditions nearly all active managers would be able to succeed. The truth lies somewhere in the middle. --
For the purposes of this study, several (particularly in large and mid-cap) and major asset classes were examined to fixed income. Growth styles tend to be identify the less efficient asset classes that less efficient, as are the satellite asset are conducive to active management classes, defined as Real Estate, High and the more efficient asset classes that Yield Bonds, Emerging Markets and are best suited for passive management Commodities. Other asset classes are mixed; requiring a judgment call as to (Table 2). Baird measured the frequency whether active or passive management that the median, or average, mutual would be most appropriate. It is worth fund in a given asset class was able noting that, while fixed income is highly to provide excess return above its efficient, in our opinion there are very benchmark (second column below). few passive options that merit anTABLE 2: investment. Many of these options have Asset % of Periods Median Efficient (favoring passive) Market short track records and have exhibited Class Fund Produces or Inefficient (favoring ac- Assets higher-than-anticipated tracking Excess Return tive) Asset Class (% Active / % Passive) error. Tracking error is the degree toTax-Exempt Fixed Income 4% Highly Efficient 99% / 1% which returns vary from the actualLarge Value 8% Efficient 9% / 8% benchmarks, something that passiveTaxable Fixed Income 9% Efficient 79% / 1% investments strive to minimize.High Yield 5% Efficient 96% / 4% Our study causes us to question whetherMid Value 40% Efficient 94% / 6% the marketplace recognizes that someMid Core 4% Mixed 59% / 41% asset classes are more efficient thanSmall Value 50% Mixed 8% / 18% others and, therefore, have a distinct biasLarge Core 54% Mixed 46% / 54% toward active or passive management.Mid Growth 55% Mixed 96% / 4% The best way to measure this is toInternational 57% Mixed 69% / 1% determine what percentage of assets inLarge Growth 67% Inefficient 9% / 7% an asset class are invested in active orSmall Core 70% Inefficient 67% / % passive managers (fourth column inCommodities 7% Inefficient 47% / 6% Table 2). Surprisingly, some of the mostEmerging Markets 75% Highly Inefficient 48% / 5% efficient asset classes are dominated by active management (e.g., Large ValueSmall Growth 80% Highly Inefficient 89% / 11% and Mid Value, both over 90% activeReal Estate 90% Highly Inefficient 6% / 7% assets) and many of the least efficient asset classes have a bias towards passive Various one-year, three-year and five- management (e.g., Emerging Markets year periods were examined over the past and Commodities, both over 50% 15 years, giving us a total of 139 distinct passive assets). This is counter-intuitive observations per asset class. For example, and leads us to the conclusion that the median Large Growth fund was many investment portfolios are not able to outperform its benchmark 67% optimally constructed. of these periods, making it a relatively All else being equal, it is our opinion inefficient asset class. Alternatively, the that active management be used where median Large Value fund outperformed it has the best chance of success, and passive management be used to round only 28% of the time, making it a fairly out the asset allocation. This may efficient asset class. lead to an optimal portfolio that plays Asset classes that tend to be highly into the strengths of the different efficient include the value styles investment options. --
What Is Average? Clearly, there is a great difference between average and above-average In the previous section on market managers, and this directly influences efficiency, we focused on the a client’s ability to meet or exceed performance of the median mutual performance expectations. While fund. In many cases, the evidence is there is no certain way to identify not a ringing endorsement for active and invest strictly in top-quartile management. Since no investor managers, the success rates of average strives to invest with an “average” versus above-average managers manager, we examined how the makes a strong case for trying to outcome would change for those identify superior options. Also, it is invested with a top-quartile manager increasingly difficult for a manager (i.e., performance that ranks in the to constantly remain a top-quartile top 25th percentile of the peer group performer over many periods. universe). For example, the median However, Baird believes that by large cap manager underperformed conducting thorough research and due diligence on investment the benchmark by 20 bps, on average, managers, it becomes easier to of all three-year periods included in identify which of them exhibit the study, while top-quartile managers the characteristics associated with added 230 bps of excess return during consistent, long-term success. those periods (1 basis point = .01%).Why Spend Time on Due Diligence? Average -Year Excess Return by Asset Class 600 500 The success of top quartile versus bottom quartile Average -Year Excess Return (bps) funds makes an investment 400 in due diligence worthwhile. 300 200 Top Quartile Fund Median Fund 100 0 (100) Large Cap Mid Cap Small Cap International Large Cap Mid Cap Small Cap International Top Quartile 0 70 570 60 Median -0 0 0 80Source: Morningstar Direct; Baird Analysis.For the 10-year period ending June 30, 2009, excess returns for individual mutual funds were collectedby asset class. The excess returns were calculated based on rolling 3-year periods (n=29). All performanceis net of the funds’ management expense ratio. -4-
The Due Diligence Process Other Important Considerations which includes lower-priced ETFs thatHow professionals choose and track major indices to higher-priced Below are the other most commonmonitor money managers options that track specific sectors or factors that should weigh into your industries. Given that ETFs and indexWhen choosing money managers, decision when choosing a money funds have similar objectives, in mostit’s clear that past performance manager. These are important topics cases you would be generally bestdoesn’t tell the full story. The to discuss with your Financial Advisor.process of identifying quality served by utilizing the lowest priced Investment Time Horizon option available to you.managers and then monitoringtheir performance over time is How soon you need the proceeds from Fees are equally as important whenknown as due diligence. In the invested assets to reach specific goals considering active managementlegal world, due diligence refers determines that investment’s time options, but the decision is a bitto the care a reasonable person horizon. Some assets are designated more complicated. First, fees varyshould take before entering into for long-term growth until retirement, more with active management,an agreement. In the investment while others may be invested in the but so does manager quality. It ismanagement world, it refers to stock market for the short-term, in generally prudent to invest in lowerthe deep investigation of a money lieu of CDs or savings accounts. In priced options because of the lowermanager that takes place before, either case, the length of the anticipated hurdle, especially in the fixed incomeduring and after that manager isrecommended to a client. holding period for those assets can arena, where the performance help dictate which solution is most spreads are already narrow. However,At Baird, a team of analysts appropriate. Baird’s studies have final judgment must be made basedconducts investment manager due shown that active managers have a on whether you and your Financialdiligence. Their goal is to minimize higher probability of success if held Advisor believe a money managerthe risk of underperformance bygaining a full understanding of for longer periods. For example, the has the requisite talent to earn thethe story behind the numbers. The frequency that a manager adds value fees by providing adequate excessprocess is continuous with equal increases from 59% to 79% by return. This is where due diligenceeffort applied to manager selection extending the holding period from becomes critical.and ongoing manager evaluation. 1 year to 3 years. Baird recommendsIt includes these steps: allowing at least one full market cycle Tax Sensitivity1. Initial manager screening of three-to-five years for most active Generally speaking, passive using a proprietary, multi-factor managers to realize the potential of investments offer investors greater tax model that encompasses 16 their strategies. For holding periods efficiency because they create fewer different factors scored over of a year or less, passive management capital gains situations due to in-kind various times periods can be a quick and effective way to distribution. Also, because of the. Preliminary and detailed portfolio gain exposure to the market without low turnover of the securities that analysis, which requires weeks high transaction costs. comprise most of the indices such of research and numerous funds are modeled after, not a lot of Investment Management Fees conversations with the trading is necessary. For active prospective money manager Management fees are an inescapable managers, however, buying and selling. On-site visits, which often lead fact of investing. Passive management securities is one way they attempt to to important observations does generally have lower fees relative add value by capturing excess returns. that cannot be garnered over to active management, but fees can This can come at the cost of increased the phone vary greatly even for investments capital gains exposure. For those striving to replicate the same clients who are very sensitive to taxes, benchmark. The average ETF expense ETFs can be a suitable option. (continued) ratio as of June 2009 was 0.54%, -5-