How The Active Vs. Passive Debate Misses The Point
Losing the Forest for the TreesHow the Active vs. Passive Debate Misses the PointMarc Odo, CFA , CAIA , CIPM , CFP
Active vs. Passive2ACTIVE VS PASSIVEThe battle between stock-picking active and indexbased passive management has been raging foryears, but in 2016 the momentum was all on theside of passive managers. BlackRock, Vanguard,and State Street occupy the top spots on theAUM tables, each passively managing trillionsof dollars. Meanwhile, traditional stock-pickingactive managers 1 have been hemorrhaging assets.According to Morningstar research 2, U.S. passivemutual funds added 492bn in 2016, whereasactive managers have shed 204bn. These numbersare for open-ended mutual funds and don’t includeETFs or the shift in institutional assets, where thesame trends are underway.In a circle-the-wagons moment, the leaders of someof the world’s largest active managers recentlygathered in New York for “The Seismic Shift SeniorLeadership Forum 3” to discuss the challengesfacing their industry. Almost all expect the trend topassive to continue. In addition to investors “votingwith their feet”, passive management is buffeted bythe tailwinds of the robo-advisor movement and theDepartment of Labor’s proposed fiduciary rule.By now the arguments for and against pickingstocks and indexing are well documented. Oceansof ink have been spilled on either side. As a briefsynopsis, here are the points people tend to makeregarding active and passive management: The Case for Passive Management/AgainstActive Management Management fees are close to zero Most active managers fail to outperformtheir benchmarks after fees Identifying active managers likely tooutperform is difficultThe Case Against Passive Management/ForActive Management Passive investing doesn’t allow for theefficient allocation of capital Noattentionpaidtovaluations,fundamentals, etc. “Herding” into overbought asset classes No chancebenchmarkofoutperformingtheAt Swan Global Investments, our take on the wholepassive-versus-active debate is a bit different.Active or passive: it doesn’t matter.Some clarification on our stance is certainly inorder. It is our opinion that the debate is focusedupon the wrong thing. The passive/activeargument is about relative performance, notabsoluteperformance.Byfocusingupondifferences measured in basis points, the investorrisks losing the forest for the trees.Yes, there will be differences between the relativeperformance of active and passive managers. But interms of absolute performance, the one thing bothactive and passive management strategies share issystematic risk. And systematic risk is the biggestthreat to an investor’s wealth.By definition, systematic risk is the risk that cannotbe diversified away. Also known as market risk,systematic risk is the price that is paid for being inthe game.And how can one quantify systematic risk? Whatdoes it look like? Well, during the dot-com bustof 2000-02, systematic risk was a loss of 47.4%.From the market peak on September 2, 2000, tothe market bottom of October 9, 2002, the S&P 500shed almost half of its value. Moreover, it wasn’tuntil October 23, 2006, months after the bottom,that the market recovered all of its losses 4.Of course, only a few short years later systematicrisk again reared its ugly head, but this time themarket losses exceeded 50%. During the financialcrisis of 2007 to 2009, the S&P 500 index wasdown 55.2% between October 10, 2007 and March9, 2009 5. Meanwhile, the debate between activeand passive is usually measured as a percentagepoint or two.1 For the purposes of this paper, “active management” refers to stock-picking strategies that seek to outperform a given benchmark through superior stock selection, rather than anytype of top-down sector rotation or tactical asset allocation strategy.2 Morningstar Asset Management Quarterly, 1Q 20173 The Wall Street Journal, “Anxious Mutual Fund Industry Holds ‘Seismic Shift Senior Leadership Forum’”, December 13, 20164 All drawdown information from Morningstar Direct.5 All drawdown information from Morningstar Direct.Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive3The bottom line is that a traditional, stock-pickingactive manager will not be able to stock-pick hisway out of systematic risk during a full blown bearmarket. Moreover, a passive manager is systematicrisk, by definition. If the market sells of by 30%,40%, 50% or more, an index manager is designedto go down with the ship. A passive manager isentirely, 100%, systematic risk.It is our opinion that if market risk cannot bediversified away, it must be hedged away. TheDefined Risk Strategy (DRS) was built on thispremise. But before we discuss the DRS, let us lookat how systematic risk impacts active and passivemoney managers across the industry.SYSTEMATIC RISK: THE 800-POUND GORILLAIn the following section, we will see how systematicrisk impacts the following classifications ofmanagers:4. Active managers across all nine Morningstarstyle boxes- Large, Mid, and Small and ValueBlend and Growth1. Index funds within the large cap blend spaceThe field of managers was scrubbed to includeonly those funds with an inception date prior toJanuary 1st, 2007. Also, duplicate share classeswere removed, leaving only the primary share class.The count of funds across these categories is asfollows:2. Active managers classified as Large Blend byMorningstar3. Active managers classified as Large Value, LargeGrowth or Large Blend by MorningstarLargeBlend:249Large Cap: 787All Domestic Equity: 1451Chart 1 Source: Morningstar Direct, Swan Global InvestmentsThe first metric we will look at is maximumdrawdown. From peak-to-trough, how much didthese managers lose? When the markets collapsedbetween mid-2007 and early-2009, were any ofthe funds in this study successful at mitigating thelosses? What were the ranges of outcomes?Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive4Maximum %30.00%20.00%10.00%IndexLarge BlendLarge Cap-5% to 0%-10% to -5%-15% to -10%-20% to -15%-25% to -20%-30% to -25%-35% to -30%-40% to -35%-45% to -40%-50% to -45%-55% to -50%-60% to -55%-65% to -60%-70% to -65%-75% to -70%More than -75%0.00%Domestic EquityChart 2 Source: Morningstar Direct, Swan Global InvestmentsMax DrawdownIndexLarge BlendLarge CapDomestic EquityMore than -75%0.00%0.00%0.00%0.07%-75% to -70%0.00%0.80%0.89%1.45%-70% to -65%0.00%2.81%3.30%5.72%-65% to -60%4.76%8.43%11.05%17.44%-60% to -55%87.30%36.55%32.53%35.08%-55% to -50%6.35%33.33%35.32%27.77%-50% to -45%1.59%13.25%13.09%9.44%-45% to -40%0.00%3.61%2.54%2.07%-40% to -35%0.00%1.20%0.89%0.55%-35% to -30%0.00%0.00%0.25%0.21%-30% to -25%0.00%0.00%0.00%0.14%-25% to -20%0.00%0.00%0.00%0.00%-20% to -15%0.00%0.00%0.00%0.00%-15% to -10%0.00%0.00%0.00%0.00%-10% to -5%0.00%0.00%0.13%0.07%-5% to 0%0.00%0.00%0.00%0.00%Table 1 Source: Morningstar Direct, Swan Global InvestmentsSwan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive5During the Financial Crisis of 2007 to 2009, thevast majority of passive and active funds lost overhalf their value in a very short time span. Onlyone fund out of 1,451 was able to lose less than25%. This is the impact of systematic, market risk.When things go wrong, the relative advantages ordisadvantages in the active versus passive debateare rendered irrelevant.most of the variation of returns. But as we expandthe circle to include first value and growth, andthen mid cap and small, we don’t see the overallpicture change very much. Almost 90% of large capgrowth, blend, and value funds have at least 80% oftheir return-variation driven by the S&P 500. Whenit comes to all domestic equity funds, 83% of themhave R 2 of 80% or higher.Another factor we can look at is R-squared, alsoknown as the coefficient of determination. R-squaredis often used as a “goodness of fit”, but its officialdefinition is the percent of a data series’ variancethat is attributable to the variance in another dataseries. For the purposes of our discussion here, R 2is used to determine the percentage of an activemanager’s variance and is driven by the variancein the market, as defined by the S&P 500. In otherwords, what percentage of an active manager’svariance is driven by systematic risk?Of course, many investors experienced this firsthand during the Financial Crisis of 2007-09. Priorto the event many investors using Modern PortfolioTheory pursued what I call “false diversification.”By allocating their equity investments across manymutual funds covering all the styles and sub-stylesof the equity spectrum investors thought they wereproperly diversified. As the above data indicates,equity investors had nowhere to hide.It should be no surprise that the vast majority ofactive and passive funds within the large blendspace have R 2 of at least 90%. The market droveThe bottom line is that systematic risk is the800-pound gorilla. Whether one chooses to investactively or passively is moot - if systematic risk isnot addressed head-on, how one picks stocks isbeside the point.Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. ndexLarge BlendLarge CapLess than 50%50% to 55%55% to 60%60% to 65%65% to 70%70% to 75%75% to 80%80% to 85%85% to 90%90% to 95%95% to 100%0.0%Domestic EquityChart 3 Source: Morningstar Direct, Swan Global InvestmentsR-squaredIndexLarge BlendLarge CapDomestic Equity95% to 100%98.4%48.6%29.5%16.1%90% to 95%1.6%36.5%37.7%24.0%85% to 90%0.0%8.4%19.4%21.2%80% to 85%0.0%4.0%8.1%22.1%75% to 80%0.0%2.0%3.0%11.0%70% to 75%0.0%0.0%1.1%3.7%65% to 70%0.0%0.0%0.1%0.8%60% to 65%0.0%0.4%0.1%0.3%55% to 60%0.0%0.0%0.5%0.6%50% to 55%0.0%0.0%0.1%0.2%Less than 50%0.0%0.0%0.1%0.1%Table 2 Source: Morningstar Direct, Swan Global InvestmentsSwan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive7WHAT ABOUT “SMART BETA?”Over the last decade or so there has been anexplosion in “smart beta” strategies. Also calledstrategic beta, fundamental indexing, factorinvesting, or enhanced indexing, the idea is usuallythe same: that there is a “third way” that combinesthe best of active and passive management.However, we would argue that smart beta suffersfrom the same flaws afflicting passive and activemanagers, namely, systematic risk is still pervasivein smart beta strategies.In order to understand smart beta strategies, it isuseful to understand where they came from andhow they evolved. In fact, even the simple dualityof passive and active is better understood if welook back to where it all started: the Capital AssetPricing Model.The last term, alpha, was an afterthought. Originallyit was expressed as an error term to set the two sidesof the equation in balance. After all, if sensitivity tosystematic risk explained all of the movements ofan asset, then any differences in the equation wouldjust be statistical noise.However, those in the active management campdidn’t see things that way. They believe that thereis a premium, a level of return that the intelligentand diligent investor can reap in excess of thesystematic risk taken. This is why those on theactive management side frequently refer to alpha as“skill”.Of course, those on the passive side of the debatewould prefer to call alpha “luck.” For them, alphais an error term. It is random, negligible, and afteraccounting for active management fees, negative.Smart Beta?”TheCapital Asset Pricing Model andPassiveInvestingade or so therehas been anexplosion in “smart beta” strategies. Also called strategicWhen John Bogle first started evangelizing thesimple-and-cheap market-average model, no oneWhataboutor“SmartBeta?”would have predicted Vanguard would have grown tol indexing, factorinvesting,enhancedindexing, the idea is usually the same: thatway” that combines the best of active and passive management. However, we wouldbecalledonestrategicof the largest money managers in existence.Over the last decade or so there has been an explosion in “smart beta” strategies. AlsoAlthoughit hasflawsbeenoverpassivehalf aandcenturysince Williambeta suffersfromthe sameafflictingactive managers,namely,beta, fundamental indexing, factor investing, or enhanced indexing, the idea is usuallytheessentiallysame: thatButthis whole active-vs-passive debatestill pervasivein smartstrategies.Sharpe,Treynor,and theJohnthere isbetaaJack“thirdway”that combinesbest ofLintneractive and developedpassive management. However,wewouldcan essentially be boiled down to a black-and-whiteargue that smartbetasuffers from thesamereverberateflaws afflicting passiveand active managers, namely,implicationsstand smartthebeta CAPM,strategies, ititsis usefulto understandstillwherethey came fromtoandthishowquestion: after accounting for systematic risk/beta,systematic risk is still pervasive in smart beta strategies.day.modeltheact, even thesimpleThedualityoriginalof passive andactive iswasbettersimple.understood Underif we look backis the remainder something that can be reliablyInorderto understandbeta strategies,it is asset,useful to understandwhere they came from and howted: the CapitalAssetPricingModel. smart returnCAPM,theexpectedof anany asset,harvested? Or is it just noise? Obviously Vanguardthey evolved. In fact, even the simple duality of passive and active is better understood if we look cing Model andwas built around the latter argument.to Passivewhere it Investingall started: the Capital Asset Pricing Model.factor. That factor was “the market”, or systematicCapitalAssetPricingModel Jackand Passiveeen over half a centurysinceWilliamSharpe,Treynor,and John Lintner e sensitivity orlications still reverberate to this day. The original model was simple. Under the CAPM,Although it hasbeenover half a century regressionsince William Sharpe,JackcourseTreynor, and John TheLintner developedcoefficientinasingle-factoris ofFama-French Three Factor Model andrn of an asset, any asset, was simply a function of its sensitivity to a single factor. Thatthe CAPM, its implications still reverberate to this day. The original model was simple. Under the CAPM,Thereturnofit.anyasset overthe riskEnhanced Indexingmarket”, or wassensitivityor coefficientin athe expectedof beenan asset,any asset,simply a functionof its sensitivityto a single factor. on is isk-freeratewasfactor was “the market”, or systematic risk as we’ve been calling it. The sensitivity or coefficient in ay be its sensitivityto marketmovements.single-factorregressionis of course beta. The excess return of any asset over the risk-free rate wasmarketmovements.It was the simplicity of the CAPM that later academicstheorized to simply be its sensitivity to market movements.𝑅𝑅𝑖𝑖 𝑅𝑅𝑟𝑟𝑟𝑟 𝛽𝛽𝑖𝑖 [𝑅𝑅𝑚𝑚𝑚𝑚𝑚𝑚 𝑅𝑅𝑟𝑟𝑟𝑟 ] 𝛼𝛼𝑖𝑖targeted. In the single-factor model, alpha seemed𝑅𝑅𝑖𝑖 𝑅𝑅𝑟𝑟𝑟𝑟 𝛽𝛽𝑖𝑖 [𝑅𝑅𝑚𝑚𝑚𝑚𝑚𝑚 𝑅𝑅𝑟𝑟𝑟𝑟 ] 𝛼𝛼𝑖𝑖to be too large to be random. Were there simply aWhere:lot of skillful active managers in the 1980’s �𝑅 𝑜𝑜𝑜𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑅𝑅𝑖𝑖 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖stocks? Or was there a systematic flaw not ��� 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑅𝑅𝑟𝑟𝑟𝑟 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖picked up by the CAPM?𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑜𝑜𝑜𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝐴𝐴𝐴𝐴𝐴𝐴ℎ𝑎𝑎 𝑜𝑜𝑜𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝛽𝛽𝑖𝑖 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑜𝑜𝑜𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡 ��𝑅𝑚𝑚𝑚𝑚𝑚𝑚 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 ��𝛼𝑖𝑖 𝐴𝐴𝐴𝐴𝐴𝐴ℎ𝑎𝑎 𝑜𝑜𝑜𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖The next big leap forward was developed by EugeneFama and Kenneth French, and was a modificationha, was an afterthought.Originallyit wasexpressed asOriginallyan error ittermto set theastwoThe last term,alpha, wasan afterthought.was expressedan error termto set thethe twooriginal CAPM. Published in the earlyuponion in balance. Afterif sensitivitysystematicthe movementssides all,of theequation intobalance.Afterriskall, ifexplainedsensitivityallto ofsystematicrisk explained all of the movementsan asset,thenwouldany differencesin the equationany differences inoftheequationjust be statisticalnoise.would just be statistical noise.However, thosethe activemanagementcampdidn’tsee thingsway.there is aSwanGlobalInvestments970-382-8901 swanglobalinvestments.comn the active managementcampindidn’tseethingsthat way.Theybelievethat thatthereis aThey believe igentinvestorcanreapinexcessofthesystematicof return that the intelligent and diligent investor can reap in excess of the systematicrisk taken. This is why those on the active management side frequently refer to alpha as “skill”.why those on the active management side frequently refer to alpha as “skill”.Of course, those on the passive side of the debate would prefer to call alpha “luck.” For them, alpha ison the passive side of the debate would prefer to call alpha “luck.” For them, alpha is
Active vs. Passive81990’s, Fama and French identified two additionalfactors that seemed to be statistically significantand persistent. Their findings indicated that smallerstocks tended to outperform larger stocks andvalue stocks tended to outperform growth stocks.After quantifying this difference or “premium”, Famaand French released what became known as the“three factor model”.It is quite similar to the CAPM, but includes thesetwo new independent variables. A few years laterMark Carhart literally added a fourth term to theequation, momentum.𝑅𝑅𝑖𝑖 𝑅𝑅𝑟𝑟𝑟𝑟 𝛽𝛽𝑖𝑖 [𝑅𝑅𝑚𝑚𝑚𝑚𝑚𝑚 𝑅𝑅𝑟𝑟𝑟𝑟] 𝛽𝛽𝑠𝑠[𝑆𝑆𝑆𝑆𝑆𝑆] 𝛽𝛽𝑣𝑣[𝐻𝐻𝐻𝐻𝐻𝐻] 𝛼𝛼𝑖𝑖𝐹𝐹𝐹𝐹Where: 𝑅𝑅𝑖𝑖 ��𝑜𝑜𝑜𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑅𝑅𝑟𝑟𝑟𝑟 ��𝑜𝑜𝑜𝑜 �� 𝛽𝛽𝑖𝑖 �� ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑡𝑡𝑡𝑡 𝑛𝑛𝑛𝑛𝑛 ��𝑓𝑅𝑅𝑚𝑚𝑚𝑚𝑚𝑚 ��𝑜𝑜𝑜𝑜 ��𝛽𝑠𝑠 𝑡𝑡 ���𝑠𝑠𝑠𝑠𝑆𝑆𝑆𝑆𝑆𝑆 𝑆 ��𝑆 𝑣 𝑡𝑡 "ℎ𝑖𝑖𝑖𝑖ℎ ��𝑙𝑙𝑙𝑙" ��𝐻𝐻𝐻𝐻𝐻 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 "ℎ𝑖𝑖𝑖𝑖ℎ �� ��� 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑜 ��𝑖𝑖𝑖𝑖𝑖𝑖𝑖It should be noted that if you add more independentvariables to the equation and if these variablesactually do increase the explanatory power of theequation, then inevitably the error term – alpha – willdecrease.For example, assume an active manager favors valuestocks and small cap stocks in their portfolio. Usingthe single-factor CAPM model, the alpha might be3.5. However, if one were to use the more robustFama-French three factor model and the systematicbias towards value and small could be quantified,the manager’s alpha might drop from 3.5 to 1.0.It was upon these theories that Dimensional FundAdvisors built their highly successful fund family.DFA commercialized the idea of the multi-factormodel and has converted many financial advisorsand investors to their creed. Instead of paying activemanagers hefty salaries to research companies andassemble portfolios, DFA instead simply assigned“value” and “small” scores to stocks, sorted themfrom highest to lowest, and built their portfoliosaround those biases 6.Factor Models and Smart BetaOnce the concept of factor-based investing andcheap computing power became widely available20 years ago, the floodgates opened. There wasa surge in quantitative money managers, manyusing Barr Rosenberg’s Barra Risk Factor Analysisplatform to construct portfolios. Out the windowwent old-fashioned fundamental stock analysis,and a whole new breed of “quants” spent their daystrying to identify new explanatory factors or designoptimization algorithms. “Enhanced indexing” wasa term that was en vogue 15 years ago; these daysit’s called “smart beta.”This idea of factor-based investing eventuallymerged with nascent exchange traded fund industryto coalesce into the “smart beta” movement. Thebasic thesis behind smart beta is that indices basedsolely upon market capitalization are lacking 7. Theidea is systematic biases exist that would generateexcess relative returns if they were over- or underweighted relative to the cap-weighted market.Every deviation from the original Capital AssetPricing model is some variation on this basicpremise. Fama-French, Carhart, BARRA, factoranalysis, smart beta it’s all variations on the sametheme.That said, there are two old sayings that one shouldkeep in mind when analyzing a quantitative, factorbased strategy. The first is, “garbage-in, garbageout.” If the inputs into a model are unreliable, theoutputs might turn out to be worse than useless.The second saying is, “if you torture the data longenough, it will confess to anything.” With so manydata points available and the immense computingpower at everyone’s fingertips, the danger of falsepositives making their way into a factor model is veryreal. One should make sure qualified statisticiansare generating the quant models, not just a guy whoknows how to run a computer.6 Of course, building a factor-based portfolio isn’t as simple as clicking “sort” on a spreadsheet. Top-down risk controls are frequently in place to control the aggregate risks.7 An interesting, often over-looked side note: the S&P 500 isn’t passively constructed. The actual construction of the index is conducted by a committee of humans, choosing stocksthat they believe best represents the U.S. economy.Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive9Another broader point to make is that statisticalmodels of any type are often wrong. In 2016 moststatistical models said the United Kingdom wouldremain within the European Union, Hillary Clintonwould be president of the U.S. and the AtlantaFalcons had an insurmountable lead over the NewEngland Patriots at halftime of Super Bowl LI.Statistical models are far from bullet proof.transition from the accumulation to distributionstages of their life cycle, and are drawing down theiraccount values to fund retirement.Finally, I do find it amusing that there is a certaindisconnect in perceptions when it comes to smartbeta. Many people accept “smart beta” as a viableinvestment strategy but “closet indexers” areregarded as charlatans unworthy of the title “portfoliomanager.” If one uses a common measuring sticklike the S&P 500 and compares the typical smartbeta portfolio against a typical benchmark-relativestock picker, one won’t see a whole lot of differencebetween their active bets.2. A traditional active manager, Growth Fund ofAmericaThird way or the same road?However, the main objection Swan GlobalInvestments has with all these strategies is thatsystematic risk remains unaddressed. In all of theCAPM-based models, the biggest factor is alwayssimple market risk. Market risk represents absoluterisk: the risk of catastrophic loss, the risk of runningout of money. This risk is especially relevant forthe investors of the baby boom generation as theyIn this section we will analyze the impact ofsystematic risk on four types of strategies, namely:1. A pure passive manager,Vanguard 500 Indexrepresentedby3. A factor-driven/smart beta strategy, DFA USLarge Cap Value4. A hedged equity approach, Swan’s Defined RiskStrategyThe technique we will use for this analysis is referredto as linear regression. It’s called a linear regressionbecause you literally draw a straight line through aplot of manager’s returns (the dependent variable)and the benchmark (the independent variable). Thegoal of the linear regression is to get a line thatbest-fits the data. As a matter of fact, the commonlyused metrics like alpha, beta, and R 2 are generatedvia a linear regression.From a statistical standpoint, this is a wellestablished technique. But from an investingstandpoint, does it really make in any sense to trackthat line of best fit? If the market is down -30%,-40%, or -50%, shouldn’t the investor try to be asfar away from that market line as possible?Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive10Below we see a linear regression for the Vanguard500 fund (VFINX) from July 1997 to December 2016,using quarterly returns. There are no surprises here.The returns of the passive fund track the S&P 500index as closely as possible; the fund is doingexactly what it should be doing. But the problem iswhen the market tanks the fund tracks it down inlock-step. In essence, it IS the market.Vanguard 500 Index - Quarterly30%20%Vanguard 500 Index Invy 0.9999x - 0.0002R² 1-30%10%0%-20%-10%0%10%20%30%-10%-20%-30%S&P 500Vanguard 500 Index InvLinear (Vanguard 500 Index Inv)Chart 4 Source: Zephyr StyleADVISOR, Swan Global InvestmentsThe equation for the regression essentially is thecapital asset pricing model we saw previously. The0.9999 coefficient is the slope of the line, known asbeta in financial circles. The error term of -0.0002is the quarterly alpha, which is slightly negative dueto fees. We see the R 2 as a perfect 1 (or 100%)meaning that 100% of the variance of returns in thefund is explained by the variance of returns in thebenchmark.Let us now look at a traditional active manager. Inthis case, we are looking at one of the most popularfunds in existence, the Growth Fund of America(AGTHX). Again, we will use the time frame July1997 to December 2016 and quarterly returns.Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive11American Funds Growth Fund of America - Quarterly30%20%American Funds Growth Fund of Amer Ay 1.0658x 0.0059R² 0.8808-30%10%0%-20%-10%0%10%20%30%-10%-20%-30%S&P 500American Funds Growth Fund of Amer AS&P 500Linear (American Funds Growth Fund of Amer A)Linear (S&P 500)Chart 5 Source: Zephyr StyleADVISOR, Swan Global InvestmentsUnlike the Vanguard index fund, the straight redline of the S&P 500 does not perfectly fit this data.However, it isn’t very difficult to draw the blue dottedline through the scatterplot and come up with asolution that captures 88.08% of the variance ofreturns. We see Growth Fund’s beta being slightlyabove 1.0 as the coefficient is 1.067 and we see asmall positive quarterly alpha, even after taking intoaccount fees. But seeing how closely the individualquarterly dots hug the red line of the S&P 500, wecan conclude that systematic risk is the primarydriver of performance.What about a factor-driven, “smart beta” strategy,like DFA US Large Value (DFLVX)? Even though thisis classified as a large cap value fund, the majorityof its returns can be explained by the S&P 500(red line). There is slightly more dispersion fromthe best fit line than we saw with Growth Fund ofAmerica, and there is a small amount of alpha inthis regression. But it is still safe to say by lookingat the blue dotted line that the DFA fund has a linearrelationship with market, for better or worse.Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive12DFA US Large Cap Value - Quarterly30%20%y 1.0567x 0.0046R² 0.794DFA US Large Cap Value I10%-30%0%-20%-10%0%10%20%-10%-20%-30%S&P 500DFA US Large Cap Value IS&P 500Linear (DFA US Large Cap Value I)Linear (S&P 500)Chart 6 Source: Zephyr StyleADVISOR, Swan Global InvestmentsSwan Global Investments 970-382-8901 swanglobalinvestments.com30%
Active vs. Passive13Swan Defined Risk Strategy - Quarterly30%Swan Defined Risk Strategy (net)y 0.2817x 0.0162R² &P 500Swan Defined Risk Strategy (net)S&P 500Linear (Swan Defined Risk Strategy (net))Linear (S&P 500)Chart 7 Source: Zephyr StyleADVISOR, Swan Global Investments. DRS returns are from the Select Composite, net of all fees. NOTE –this chart is for illustration purposes, not a guarantee of future performance. The charts and graphs contained herein should not serveas the sole determining factor for making investment decisions.Finally, let’s turn our attention to the Defined RiskStrategy. The dots of the scatterplot resemble moreof a cloud than a straight line. It is possible to draw aline through the data, but the blue, dotted regressionline doesn’t do a very good job of explaining theDRS’s performance.The R 2 “goodness of fit” is only 21.5%. The slopeof the line is flat-ish, and the quarterly beta is thuslow. There is positive alpha, meaning there hasbeen an excess return harvested for the amount ofrisk taken.Vanguard, American and DFA were chosen asrepresentatives for the different investmentapproaches due to their popularity with investorsand their long track records. However, based uponthe results seen in the first section, I could have runsimilar regression analysis on just about any of the1,451 mutual funds in the domestic equity space,and the vast majority of funds would have hadscatterplots that looked very similar to American orDFA. This is why at the outset of the paper we madethe claim that the decision between active andpassive management is not the debate we shouldbe having. Real risk, the risk we should be focusedupon, is systematic risk.Although using monthly or quarterly data gives usmore robust regressions and coefficients, peopleoften think of markets in terms of calendar years.Let us review the same strategies, this time usingcalendar years as plot points rather than quarterlyreturns.Swan Global Investments 970-382-8901 swanglobalinvestments.com
Active vs. Passive14Vanguard 500 Index - Annual50%40%y 0.999x - 0.0009R² 130%Vanguard 500 Index 0%-20%-30%-40%-50%S&P 500Vanguard 500 Index InvLinear (Vanguard 500 Index Inv)Chart 8
The battle between stock-picking active and index-based passive management has been raging for . years, but in 2016 the momentum was all on the side of passive managers. BlackRock, Vanguard, and State Street occupy the top spots on the AUM tables, each passively managing trillions of dollars. Meanwhile, traditional stock-picking active managers. 1
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Le genou de Lucy. Odile Jacob. 1999. Coppens Y. Pré-textes. L’homme préhistorique en morceaux. Eds Odile Jacob. 2011. Costentin J., Delaveau P. Café, thé, chocolat, les bons effets sur le cerveau et pour le corps. Editions Odile Jacob. 2010. 3 Crawford M., Marsh D. The driving force : food in human evolution and the future.
