Active Vs. Passive Money Management - Baird

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 1,000ETFs 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 consideredwhen deciding between active andpassive management. These factors varygreatly from one client to another andthe solutions can be just as unique,ranging from a purely passive to purelyactive approach or some combinationof both. The correct use of thesestrategies can help build a portfoliobetter suited to your specific needs.Active vs. Passive ManagementDefinedThe difference between active andpassive investment managementlies primarily in the stated goaland the approach used to reach it.Active management is overseen byinvestment professionals striving tooutperform specific benchmarks.Passive management (i.e., index ETFs,index funds) attempts to replicatethe return pattern of a specificbenchmark. With active management,investment experts are hired basedon the perceived value they can addabove and beyond the benchmark.Passive management often stresses lowcosts, tax efficiency and the concept ofmarket efficiency.TABLE 1:Passive Management enerally lower than activeGmanagementGenerally tax efficientKey FeatureActive ManagementInvestmentManagement FeesGenerally higher thanpassive managementTax EfficiencyDepends on theinvestment managerNoPotential forAbove-Market ReturnsYesYes, after incorporating feesPotential forBelow-Market ReturnsYesNoPotential forDown Market ProtectionYesS eeks to replicate theperformance of the benchmarkDecision Making ProcessSeeks to capitalize onmarket conditions-2-As Table 1 shows, there are tradeoffsbetween the costs and potentialbenefits of the two approaches. Passivemanagement will maintain exposureto the market, but not offer anypotential for above-benchmark returns(or down market protection). Activemanagement offers the potential forabove-market returns, but comes withthe chance that the manager won’tbeat the stated benchmark. Also,neither approach can completelyshelter you from the possibility ofbelow-market returns. These variablesand the nuances of your specificsituation make this a decision bestmade with the assistance of yourFinancial Advisor. The remainderof this paper should help guide youthrough that decision-making processby offering examples of when, where,and how Baird believes active orpassive strategies should be used.Implementation of Activeand Passive StrategiesProceeding from the conclusion thatboth active and passive managementare valid strategies, the questionbecomes where and when is one moreappropriate than the other? Thefollowing pages will outline severalcommon considerations.The Truth of Market EfficiencyMarket efficiency is the degree towhich stock prices reflect all availableinformation. In a perfectly efficientmarket, all stocks are precisely valuedand no active manager has the abilityto outperform the market. If themarket were completely inefficient,nearly all active managers wouldbe able to succeed. The truth liessomewhere in the middle.

For the purposes of this study, severalmajor asset classes were examined toidentify the less efficient asset classes thatare conducive to active managementand the more efficient asset classes thatare best suited for passive management(Table 2). Baird measured the frequencythat the median, or average, mutualfund in a given asset class was ableto provide excess return above itsbenchmark (second column below).TABLE 2:% of Periods MedianFund ProducesExcess ReturnEfficient (favoringpassive) or Inefficient(favoring active)Asset ClassHigh Yield Bond16%Efficient91% / 9%Taxable Fixed Income18%Efficient77% / 23%Emerging Markets32%Efficient54% / 46%Mid Cap Core36%Efficient50% / 50%Tax Exempt Fixed Income37%Efficient97% / 3%Real Estate40%Mixed63% / 37%Mid Cap Value43%Mixed84% / 16%Large Cap Value44%Mixed87% / 13%Mid Cap Growth51%Mixed95% / 5%International Core57%Mixed65% / 35%Small Cap Growth59%Mixed88% / 12%Large Cap Growth60%Inefficient91% / 9%International Value62%Inefficient85% / 15%Large Cap Core63%Inefficient40% / 60%Small Cap Value65%Inefficient69% / 31%Small Cap Core73%Inefficient59% / 41%International Growth88%Inefficient99% / 1%AssetClassMarketAssets(% Active / % Passive)Various one-year, three-year and fiveyear periods were examined over the past15 years, giving us a total of 139 distinctobservations per asset class. For example,the median Large Growth fund wasable to outperform its benchmark 67%of these periods, making it a relativelyinefficient asset class. Alternatively, themedian Large Value fund outperformedonly 28% of the time, making it a fairlyefficient asset class.-3-Asset classes that tend to be moreefficient include the value styles(with the exception of small cap) andfixed income. Growth and small capstyles tend to be less efficient. Otherasset classes are mixed; requiring ajudgment call as to whether active orpassive management would be mostappropriate. It is worth noting that,while fixed income is highly efficient,in our opinion there are few passiveoptions that merit an investment. Manyof these options have exhibited higherthan-anticipated tracking error. Trackingerror is the degree to which returns varyfrom the actual benchmarks, somethingthat passive investments strive tominimize. Another potential concernis that most popular bond indices aremarket-weighted, so passive strategiesare often biased towards issuers with themost outstanding debt. For this reason,passive fixed income strategies typicallyhave heavy exposure to US treasuriesand other government securities.Our study causes us to question whetherthe marketplace recognizes that someasset classes are more efficient thanothers and, therefore, have a distinct biastoward active or passive management.The best way to measure this is todetermine what percentage of assets inan asset class are invested in active orpassive managers (fourth column inTable 2). Surprisingly, some of the moreefficient asset classes are dominated byactive management (e.g., Large Valueand Mid Value, both over 80% activeassets) and many of the less efficientasset classes have more passivemanagement (e.g., Large Core and SmallCore, both over 40% passive assets).This is counter-intuitive and leads us tothe conclusion that many investmentportfolios are not optimally constructed.

All else being equal, it is our opinionthat active management be usedwhere it has the best chance ofsuccess, and passive management beused to round out the assetallocation. This may lead to anoptimal portfolio that plays intothe strengths of the differentinvestment options.What Is Average?In the previous section on marketefficiency, we focused on theperformance of the median mutualfund. In many cases, the evidence isnot a ringing endorsement for activemanagement. Since no investorstrives to invest with an “average”manager, we examined how theoutcome would change for thoseinvested with a top-quartile manager(i.e., performance that ranks in thetop 25th percentile of the peer groupuniverse). For example, the medianlarge cap manager outperformed thebenchmark by 50 bps, on average, ofall three-year periods included in thestudy, while top-quartile managersadded 310 bps of excess return duringthose periods (1 basis point .01%).Clearly, there is a great differencebetween average and above-averagemanagers, and this directly influencesa client’s ability to meet or exceedperformance expectations. Whilethere is no certain way to identifyand invest strictly in top-quartilemanagers, the success rates of averageversus above-average managersmakes a strong case for trying toWhy Spend Time on Due Diligence?Average 3-Year Excess Return (bps)Average 3-Year Excess Return by Asset ClassThe success of top quartileversus bottom quartilefunds makes an investmentin due diligence worthwhile.600500400300Top Quartile Fund200Median Fund1000(100) Large CapLarge CapMid CapMid CapSmallCapCapSmallInternationalInternationalTop Quartile310350510350Median5030170100Source: Morningstar Direct; Baird Analysis.For the 15-year period ending March 31, 2012, excess returns for individual mutual funds were collectedby asset class. The excess returns were calculated based on rolling 3-year periods (n 49). All performanceis gross of the funds’ management expense ratio.-4-