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Active vs. Passive Money Management
Exploring the costs and benefits of two alternative
investment approaches
By Baird’s Advisory Services Research


Synopsis
Proponents of active and passive investment management styles have
made exhaustive and valid arguments for and against both approaches.
Each has its merits and inherent drawbacks, and this paper will not
endorse one style over the other. Rather, our goal is to define the
characteristics of each approach in an effort to help you determine
which best suits your needs and preferences.
Investors encounter different opportunities and challenges at different
times, which can help determine the investment management approach
that is the best for them. On one hand, we believe active management
can add value when coupled with strict due diligence services. On the
other hand, when limited investment options are available or the best you
can do is “average” performance, passive investment options may make
more sense due to fees and other considerations. Regardless, a clearer
understanding of how to balance and leverage both active and passive
management is crucial to realizing your investment objectives.

The Basics of Active and Passive Management
The proliferation of passive management strategies in recent years is well
documented and evidenced by the exponential growth of the Exchange
Traded Fund (ETF) marketplace. Currently there are more than 800
ETFs available; many of these employ passive strategies and range from
those replicating the widely-recognized S&P 500 Index to more niche
indexes such as the S&P Global Water Index. Passive management has
proven a viable strategy and is challenging the more traditional portfolio
construction 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 question
TABLE 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 an
TABLE 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 to
Tax-Exempt Fixed Income           4%                 Highly Efficient               99% / 1%
                                                                                                           which returns vary from the actual
Large Value                     8%                       Efficient                 9% / 8%
                                                                                                           benchmarks, something that passive
Taxable Fixed Income            9%                       Efficient                 79% / 1%              investments strive to minimize.
High Yield                      5%                       Efficient                 96% / 4%
                                                                                                           Our study causes us to question whether
Mid Value                       40%                       Efficient                 94% / 6%
                                                                                                           the marketplace recognizes that some
Mid Core                        4%                        Mixed                    59% / 41%              asset classes are more efficient than
Small Value                     50%                        Mixed                    8% / 18%              others and, therefore, have a distinct bias
Large Core                      54%                        Mixed                    46% / 54%              toward active or passive management.
Mid Growth                      55%                        Mixed                    96% / 4%               The best way to measure this is to
International                   57%                        Mixed                    69% / 1%              determine what percentage of assets in
Large Growth                    67%                     Inefficient                 9% / 7%               an asset class are invested in active or
Small Core                      70%                     Inefficient                 67% / %              passive managers (fourth column in
Commodities                     7%                     Inefficient                 47% / 6%              Table 2). Surprisingly, some of the most
Emerging Markets                75%                 Highly Inefficient              48% / 5%
                                                                                                           efficient asset classes are dominated by
                                                                                                           active management (e.g., Large Value
Small Growth                    80%                 Highly Inefficient              89% / 11%
                                                                                                           and Mid Value, both over 90% active
Real 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               80


Source: Morningstar Direct; Baird Analysis.

For the 10-year period ending June 30, 2009, excess returns for individual mutual funds were collected
by asset class. The excess returns were calculated based on rolling 3-year periods (n=29). All performance
is net of the funds’ management expense ratio.
                                                                                                 -4-
The Due Diligence Process                 Other Important Considerations               which includes lower-priced ETFs that
How professionals choose and                                                           track major indices to higher-priced
                                          Below are the other most common
monitor money managers                                                                 options that track specific sectors or
                                          factors that should weigh into your
                                                                                       industries. Given that ETFs and index
When choosing money managers,             decision when choosing a money
                                                                                       funds have similar objectives, in most
it’s clear that past performance          manager. These are important topics
                                                                                       cases you would be generally best
doesn’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 monitoring
their performance over time is            How soon you need the proceeds from          Fees are equally as important when
known as due diligence. In the            invested assets to reach specific goals      considering active management
legal world, due diligence refers         determines that investment’s time            options, but the decision is a bit
to the care a reasonable person           horizon. Some assets are designated          more complicated. First, fees vary
should 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 is
management world, it refers to
                                          stock market for the short-term, in          generally prudent to invest in lower
the deep investigation of a money
                                          lieu of CDs or savings accounts. In          priced options because of the lower
manager that takes place before,
                                          either case, the length of the anticipated   hurdle, especially in the fixed income
during and after that manager is
recommended 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 based
conducts investment manager due
                                          shown that active managers have a            on whether you and your Financial
diligence. Their goal is to minimize
                                          higher probability of success if held        Advisor believe a money manager
the risk of underperformance by
gaining a full understanding of
                                          for longer periods. For example, the         has the requisite talent to earn the
the story behind the numbers. The         frequency that a manager adds value          fees by providing adequate excess
process is continuous with equal          increases from 59% to 79% by                 return. This is where due diligence
effort applied to manager selection       extending the holding period from            becomes critical.
and ongoing manager evaluation.           1 year to 3 years. Baird recommends
It includes these steps:                  allowing at least one full market cycle      Tax Sensitivity
1. 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-
(continued from previous page)                Market Conditions                         Conclusion
                                                                  Evidence suggests that certain market     There is no consensus regarding which
   4. Written investment thesis that
                                                                  conditions favor active or passive        approach provides superior results.
       consolidates all information
       gathered in the prior steps to
                                                                  management. Actively managed              With proper due diligence, active
       answer the question, “Why                                  investments have historically performed   management has the potential to
       should clients invest with                                 better than passively managed             provide above-market returns. However,
       this manager?”                                             investments when the markets are          passive management creates a level of
                                                                  decidedly negative, or in flat-to-        consistency, knowing that investment
   5. Committee approvals to
       ensure full agreement that                                 moderate markets. Conversely,             performance will not vary greatly from
       the manager is an acceptable                               passive investments have generally        the benchmark. Before making a
       investment option                                          outperformed in swiftly rising markets.   decision, it is important to consider your
                                                                  While there are exceptions to these       expected time horizon, tax sensitivity,
   6. Ongoing due diligence used
       to assess consistency among
                                                                  dynamics, understanding when market       ability to tolerate performance variation
       people, process, philosophy                                conditions are favorable or unfavorable   and other factors. Your Financial Advisor
       and performance                                            for an investment style is important      can help you weigh your objectives and
                                                                  in managing expectations.                 concerns to determine which approach
   Although it is easy for investors to
   access historical performance data,
                                                                                                            is most appropriate for you.
   deeper information becomes much
   more difficult to uncover. A robust
   due diligence process can bridge
   that gap. Understanding the drivers
   of performance can significantly
   improve our chances of identifying
   high performing managers.




ETFs are subject to the same risks as their underlying securities, trade on an exchange throughout the day and redemptions
may be limited and, if purchased outside of a fee-based portfolio, brokerage commissions are charged on each trade.
Past performance is not a guarantee of future results and no investment, regardless of the length of time held, is guaranteed
to be profitable. Indices are unmanaged and an investment cannot be made directly in one.
Investors should consider the investment objectives, risks, charges and expenses of any fund carefully before investing.
This and other information is found in the prospectus. For a prospectus, contact your Baird Financial Advisor. Please
read the prospectus carefully before investing.




                                                                                     -6-
© 009 Robert W. Baird  Co. Incorporated. www.rwbaird.com 800-RW-BAIRD                                                               MC-6545 First use: 10/09

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Active vs. Passive Money Management - Dec. 2011

  • 1. Active vs. Passive Money Management Exploring the costs and benefits of two alternative investment approaches By Baird’s Advisory Services Research Synopsis Proponents of active and passive investment management styles have made exhaustive and valid arguments for and against both approaches. Each has its merits and inherent drawbacks, and this paper will not endorse one style over the other. Rather, our goal is to define the characteristics of each approach in an effort to help you determine which best suits your needs and preferences. Investors encounter different opportunities and challenges at different times, which can help determine the investment management approach that is the best for them. On one hand, we believe active management can add value when coupled with strict due diligence services. On the other hand, when limited investment options are available or the best you can do is “average” performance, passive investment options may make more sense due to fees and other considerations. Regardless, a clearer understanding of how to balance and leverage both active and passive management is crucial to realizing your investment objectives. The Basics of Active and Passive Management The proliferation of passive management strategies in recent years is well documented and evidenced by the exponential growth of the Exchange Traded Fund (ETF) marketplace. Currently there are more than 800 ETFs available; many of these employ passive strategies and range from those replicating the widely-recognized S&P 500 Index to more niche indexes such as the S&P Global Water Index. Passive management has proven a viable strategy and is challenging the more traditional portfolio construction practice of investing strictly in active managers.
  • 2. 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 question TABLE 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. --
  • 3. 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 an TABLE 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 to Tax-Exempt Fixed Income 4% Highly Efficient 99% / 1% which returns vary from the actual Large Value 8% Efficient 9% / 8% benchmarks, something that passive Taxable Fixed Income 9% Efficient 79% / 1% investments strive to minimize. High Yield 5% Efficient 96% / 4% Our study causes us to question whether Mid Value 40% Efficient 94% / 6% the marketplace recognizes that some Mid Core 4% Mixed 59% / 41% asset classes are more efficient than Small Value 50% Mixed 8% / 18% others and, therefore, have a distinct bias Large Core 54% Mixed 46% / 54% toward active or passive management. Mid Growth 55% Mixed 96% / 4% The best way to measure this is to International 57% Mixed 69% / 1% determine what percentage of assets in Large Growth 67% Inefficient 9% / 7% an asset class are invested in active or Small Core 70% Inefficient 67% / % passive managers (fourth column in Commodities 7% Inefficient 47% / 6% Table 2). Surprisingly, some of the most Emerging Markets 75% Highly Inefficient 48% / 5% efficient asset classes are dominated by active management (e.g., Large Value Small Growth 80% Highly Inefficient 89% / 11% and Mid Value, both over 90% active Real 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. --
  • 4. 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 80 Source: Morningstar Direct; Baird Analysis. For the 10-year period ending June 30, 2009, excess returns for individual mutual funds were collected by asset class. The excess returns were calculated based on rolling 3-year periods (n=29). All performance is net of the funds’ management expense ratio. -4-
  • 5. The Due Diligence Process Other Important Considerations which includes lower-priced ETFs that How professionals choose and track major indices to higher-priced Below are the other most common monitor money managers options that track specific sectors or factors that should weigh into your industries. Given that ETFs and index When choosing money managers, decision when choosing a money funds have similar objectives, in most it’s clear that past performance manager. These are important topics cases you would be generally best doesn’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 monitoring their performance over time is How soon you need the proceeds from Fees are equally as important when known as due diligence. In the invested assets to reach specific goals considering active management legal world, due diligence refers determines that investment’s time options, but the decision is a bit to the care a reasonable person horizon. Some assets are designated more complicated. First, fees vary should 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 is management world, it refers to stock market for the short-term, in generally prudent to invest in lower the deep investigation of a money lieu of CDs or savings accounts. In priced options because of the lower manager that takes place before, either case, the length of the anticipated hurdle, especially in the fixed income during and after that manager is recommended 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 based conducts investment manager due shown that active managers have a on whether you and your Financial diligence. Their goal is to minimize higher probability of success if held Advisor believe a money manager the risk of underperformance by gaining a full understanding of for longer periods. For example, the has the requisite talent to earn the the story behind the numbers. The frequency that a manager adds value fees by providing adequate excess process is continuous with equal increases from 59% to 79% by return. This is where due diligence effort applied to manager selection extending the holding period from becomes critical. and ongoing manager evaluation. 1 year to 3 years. Baird recommends It includes these steps: allowing at least one full market cycle Tax Sensitivity 1. 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-
  • 6. (continued from previous page) Market Conditions Conclusion Evidence suggests that certain market There is no consensus regarding which 4. Written investment thesis that conditions favor active or passive approach provides superior results. consolidates all information gathered in the prior steps to management. Actively managed With proper due diligence, active answer the question, “Why investments have historically performed management has the potential to should clients invest with better than passively managed provide above-market returns. However, this manager?” investments when the markets are passive management creates a level of decidedly negative, or in flat-to- consistency, knowing that investment 5. Committee approvals to ensure full agreement that moderate markets. Conversely, performance will not vary greatly from the manager is an acceptable passive investments have generally the benchmark. Before making a investment option outperformed in swiftly rising markets. decision, it is important to consider your While there are exceptions to these expected time horizon, tax sensitivity, 6. Ongoing due diligence used to assess consistency among dynamics, understanding when market ability to tolerate performance variation people, process, philosophy conditions are favorable or unfavorable and other factors. Your Financial Advisor and performance for an investment style is important can help you weigh your objectives and in managing expectations. concerns to determine which approach Although it is easy for investors to access historical performance data, is most appropriate for you. deeper information becomes much more difficult to uncover. A robust due diligence process can bridge that gap. Understanding the drivers of performance can significantly improve our chances of identifying high performing managers. ETFs are subject to the same risks as their underlying securities, trade on an exchange throughout the day and redemptions may be limited and, if purchased outside of a fee-based portfolio, brokerage commissions are charged on each trade. Past performance is not a guarantee of future results and no investment, regardless of the length of time held, is guaranteed to be profitable. Indices are unmanaged and an investment cannot be made directly in one. Investors should consider the investment objectives, risks, charges and expenses of any fund carefully before investing. This and other information is found in the prospectus. For a prospectus, contact your Baird Financial Advisor. Please read the prospectus carefully before investing. -6- © 009 Robert W. Baird Co. Incorporated. www.rwbaird.com 800-RW-BAIRD MC-6545 First use: 10/09