|
Outline for discussion
References:
Spotlighting Common Methodological Biases in Active vs. Passive Studies- Blanchette/ Israelsen.
Schwab white paper. See
Yale Active Investing study. See How Active is Your Fund Manager? A New Measure That Predicts Performance http://ssrn.com/abstract=891719
Questions to consider
1. Market cap- Is indexing more favorable with large cap?
2. International Indexing? Manager Inefficient market selection.
3. Weighting. Cap Weight- equal weight- fundamental weight
4. Relative performance.
5. Cost of investing.
Discuss these hypotheses:
There is room for both styles
_ Active may be a better choice
• In certain asset classes
• If you think you can identify a top-quartile manager
• If your client is tax-sensitive
_
Passive may be better choice
• For cost-sensitive clients looking for lower fees & expenses
• For broad market exposure
• For clients who want market beta
Favorable portfolio attributes
• Large investment capacity
• Low fees and expenses
• Diversification
• Broad market exposure
Most active managers don’t beat index returns
• It’s very hard to pick the winning managers (or stocks)
Active management is a better choice in certain markets…
• Emerging markets
• Small cap
• Intermediate U.S. bonds
…or where there are poorly specified, multiple betas
• New energy
• Gold
• Global flexible asset allocation
Efficient Market Hypothesis: The market is efficient
because prices are always fair and quickly reflective of
information. As a result, you cannot beat the market
- versus –
_ Market Failure Hypothesis: The market is not efficient.
Imperfect information, human emotions of fear and
greed and calendar anomalies are examples of some
of the factors that can lead to security mispricings
which savvy investors can exploit to their advantage.
Arguments For Active :
• Potential for higher return as well as lower volatility
• Professional analysis & research based on experience, judgment & prevailing market trends
• Ability to capitalize on trends with varied sector weights
• Managers can use defensive / protective strategies if they believe the market may go down
• Customization, tax sensitivity
Arguments Against:
• Fees
• Mistakes can happen
• Style issues – at any given time, a manager’s style might be in or out of favor
Tax Sensitivity
_ Index funds defer (rather than eliminate) taxes
_ Active managers can harvest losses to offset gains to
lower or eliminate cap gains taxes
_ Gifting appreciated stock (rather than cash) can give
investors an up-front tax deduction and tax-free
diversification
• Index fund shares can be donated as well, but you can’t choose
the highly appreciated stocks that will net the largest tax benefit
Pay for Alpha not Beta
Buying a passive index is buying beta, not alpha
You make money when the market is up, and you lose
money when the market is down.
Active managers have tools at their disposal
• Underweight / overweight sectors
• Allocation and style choice
• Downside protection (active managers typically outperform in
down markets because they can shift their portfolios
accordingly)
Passive management is about returns, not risk.
• There are certain segments of the market, such as international,*
where the volatility of an active portfolio is about the same as a
passive portfolio.
• Since the absolute downside risks aren’t all that different between
active and passive, and if you think that you have a good chance of
picking a winning active manager, why wouldn’t you choose active
over passive?
An index isn’t a portfolio
• No risk-aware portfolio construction involved
• Concentration issues
• In March 2000, market cap of Cisco = almost half the GDP of France!
• 2000 – 2002 bear market: S&P 500 declined -46.6%
*Represented by the Morgan Stanley Capital International Europe, Australasia and Far East (MSCI-EAFE) Index
Can active managers outperform?
• Active managers possess superior investment prowess in the
form of either security selection or market timing (Wermers, 2000)
• Some active fund managers possess legitimate stock selection
skills (Baker, Litov, Wachter & Wrugler, 2005)
• There have been many fund managers who have been able to
profitably rebalance their portfolios in advance of general market
movements (Bollen & Busse, 2001)
• Managers who exhibit more investment discipline produce
superior returns. Managers who do a better job of controlling
their tracking error outperform both passive portfolios and other
active managers with less risk-budgeting prowess (Alford, Jones &
Winkelmann, 2003
Empirical study by W. Van Harlow & Keith Brown
(2006) published in the Journal of Investment
Management :
• While the median manager does not match return expectations
on either a backward- or forward-looking basis, a considerable
percentage of managers do exceed that hurdle.
• There is a relationship between a certain set of observable
characteristics and the fund’s subsequent investment
performance, in particular past performance (consistent with
the notion that superior performance tends to persist over time)
• Using their findings, investors can increase their probability of
selecting an active manager whose future risk-adjusted returns
will exceed expectations
Source:Active vs. Passive Investing: Putting the Debate into Perspective. C. Schwab webcast
|