Active Vs. Passive Money Management Exploring the Costs and Benefits of Two Alternative Investment Approaches

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Active vs. Passive Money Management Exploring the costs and benefits of two alternative investment approaches

By Baird’s Asset Manager 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 1,000 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 No Yes which stock prices reflect all available Above-Market Returns information. In a perfectly efficient Potential for Yes, after incorporating fees Yes Below-Market Returns market, all stocks are precisely valued 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 Decision-Making Process market were completely inefficient, performance of the benchmark market conditions nearly all active managers would be able to succeed. The truth lies somewhere in the middle.

- 2 - For the purposes of this study, several Asset classes that tend to be more major asset classes were examined to efficient include large cap equities and identify the less efficient asset classes that fixed income. Small- and mid-cap are conducive to active management styles tend to be less efficient. Other and the more efficient asset classes that asset classes are mixed, requiring a are best suited for passive management judgment call as to whether active or passive management would be most (Table 2). Baird measured the frequency appropriate. It is worth noting that while that the median, or average, mutual fixed income is toward the efficient end fund in a given asset class was able of the scale, in our opinion there are few to provide excess return above its passive options that merit investment. TABLE 2: benchmark (second column below). Many of these options have exhibited higher-than-anticipated tracking error. Efficient (favoring Tracking error is the degree to which % of Periods Median Market Asset passive) or Inefficient Fund Produces Assets returns vary from the actual benchmarks, Class (favoring active) Excess Return (% Active / % Passive) Asset Class something that passive investments strive to minimize. Another potential concern Large Cap Core 20% Efficient 31% / 69% is that most popular bond indices are Tax Exempt Fixed Income 40% Mixed 95% / 5% market-weighted, so passive strategies Large Cap Value 41% Mixed 81% / 19% are often biased toward issuers with the Taxable Fixed Income 41% Mixed 67% / 33% most outstanding debt. For this reason, Large Cap Growth 45% Mixed 96% / 4% passive fixed income strategies typically High Yield Bond 47% Mixed 88% / 12% have heavy exposure to U.S. treasuries International Value 48% Mixed 73% / 27% and other government securities. Our Global Real Estate 51% Mixed 63% / 37% study causes us to question whether the International Core 51% Mixed 47% / 53% marketplace recognizes that some asset International Growth 54% Mixed 99% / 1% classes are more efficient than others Small Cap Core 63% Inefficient 44% / 56% and, therefore, have a distinct bias Emerging Markets 64% Inefficient 60% / 40% toward active or passive management. Real Estate 65% Inefficient 45% / 55% The best way to measure this is to Small Cap Value 67% Inefficient 58% / 42% determine what percentage of assets in Mid Cap Growth 68% Inefficient 90% / 10% an asset class are invested in active or Mid Cap Value 69% Inefficient 81% / 19% passive managers (fourth column in Mid Cap Core 72% Inefficient 28% / 72% Table 2). Large Growth is dominated Small Cap Growth 74% Inefficient 86% / 14% by active management (96%), and it is a fairly efficient asset class. On Source: Morningstar Direct; Baird Analysis. the other hand, some inefficient asset Various one-year, three-year and five- classes, such as Small-Cap Core and year periods were examined over the past Mid-Cap Core, have a high percentage 15 years, giving us a total of 147 distinct of passive managers (both above 50%). observations per asset class. For example, This is counterintuitive and leads us to the median Small Value fund was able to the conclusion that some investment outperform its benchmark 67% of these portfolios are not optimally constructed. periods, making it a relatively inefficient All else being equal, it is our opinion asset class. Alternatively, the median that active management be used where Large-Cap Core fund outperformed it has the best chance of success, and only 20% of the time, making it a fairly passive management be used to round efficient asset class. out the asset allocation. This may lead to

- 3 - an optimal portfolio that plays into added 409 bps of excess return during the strengths of the different those periods. (1 basis point = .01%) investment options. Clearly, there is a great difference What Is Average? between average and above-average managers, and this directly influences In the previous section on market a client’s ability to meet or exceed efficiency, we focused on the performance expectations. While performance of the median mutual there is no certain way to identify fund. Since no investor strives to and invest strictly in top-quartile invest with an “average” manager, managers, the success rates of average we examined how the outcome versus above-average managers would change for those invested makes a strong case for trying to with a top-quartile manager (i.e., identify superior options. Also, it is performance that ranks in the top increasingly difficult for a manager 25th percentile of the peer group to constantly remain a top-quartile universe). For example, the median performer over many periods. mid-cap manager outperformed the However, Baird believes that by benchmark by 198 bps, on average, conducting thorough research and for three-year periods included in the due diligence on investment study, while top-quartile managers managers, it becomes easier to

Why Spend Time on Due Diligence?

Average 3-Year Excess Return by Asset Class 800

700 The success of top quartile versus bottom quartile 600 funds makes an investment in due diligence worthwhile. 500

400

300 Top-Quartile Fund Median Fund

Average 3-Year Excess Return (bps) Excess 3-Year Average 200

100

-100 Large Cap Mid Cap Small Cap International

Large Cap Mid Cap Small Cap International Top Quartile 158 409 471 178 Median -23 198 224 -17

Source: Morningstar Direct; Baird Analysis. For the 15-year period ending January 31, 2015, excess returns for individual mutual funds were collected by asset class. The excess returns were calculated based on rolling three-year periods (n=49). All performance is gross of the funds’ management expense ratio. - 4 -

The Due Diligence Process identify which of them exhibit replicate the same benchmark. The How professionals choose and the characteristics associated with average ETF expense ratio as of monitor money managers consistent, long-term success. December 2015 was 0.56%, which includes lower-priced ETFs that track When choosing money managers, Other Important Considerations major indices and higher-priced it’s clear that past performance Below are the other most common doesn’t tell the full story. The options that track specific sectors or factors that should weigh into your process of identifying quality industries. Given that ETFs and index decision when choosing a money managers and then monitoring funds have similar objectives, in most manager. These are important topics their performance over time is cases you would be generally best known as due diligence. In the to discuss with your Financial Advisor. served by utilizing the lowest-priced legal world, due diligence refers Investment Time Horizon option available to you. to the care a reasonable person How soon you need the proceeds from Fees are equally as important when should take before entering into considering active management an agreement. In the investment invested assets to reach specific goals management world, it refers to determines that investment’s time options, but the decision is a bit the deep investigation of a money horizon. Some assets are designated for more complicated. First, fees vary manager that takes place before, long-term growth until retirement, more with active management, but during and after that manager is while others may be invested in the so does manager quality. It is recommended to a client. stock market for the short-term, in lieu generally prudent to invest in At Baird, a team of analysts of CDs or savings accounts. In either lower-priced options because of the conducts investment manager due case, the length of the anticipated lower hurdle, especially in the fixed diligence. Their goal is to minimize holding period for those assets can help income arena, where the the risk of underperformance by dictate which solution is most performance spreads are already gaining a full understanding of appropriate. Baird’s studies have shown narrow. However, final judgment the story behind the numbers. The that active managers have a higher must be made based on whether you process is continuous with equal probability of success if held for longer and your Financial Advisor believe a effort applied to manager selection periods. For example, the frequency money manager has the requisite and ongoing manager evaluation. It that a manager adds value increases talent to earn the fees by providing includes these steps: from 59% to 73% by extending the adequate excess return. This is where 1. Initial manager screening holding period from one year to five due diligence becomes critical. using a proprietary, multifactor years. Baird recommends allowing at Tax Sensitivity model that encompasses 16 least one full market cycle of three-to- different factors scored over five years for most active managers to Generally speaking, passive various times periods realize the potential of their strategies. investments offer investors greater tax 2. Preliminary and detailed portfolio For holding periods of a year or less, efficiency because they create fewer analysis, which requires weeks passive management can be a quick and capital gains situations due to in-kind of research and numerous effective way to gain exposure to the distribution. Also, because of the low conversations with the market without high transaction costs. turnover of the securities that prospective money manager comprise most of the indices such Investment Management Fees 3. On-site visits, which often lead funds are modeled after, not a lot of to important observations Management fees are an inescapable trading is necessary. For active that cannot be garnered over fact of investing. Passive management managers, however, buying and selling the phone generally has lower fees relative to securities is one way they attempt to active management, but fees can vary add value by capturing excess returns. greatly even for investments striving to This can come at the cost of increased (continued)

- 5 - (continued from previous page) capital gains exposure. For those clients Conclusion who are very sensitive to taxes, ETFs can There is no consensus regarding which 4. Written investment thesis that be a suitable option. consolidates all information approach provides superior results. With Market Conditions gathered in the prior steps to proper due diligence, active management answer the question, “Why Evidence suggests that certain market has the potential to provide above- should clients invest with conditions favor active or passive market returns. However, passive this manager?” management. Actively managed management creates a level of 5. Committee approvals to investments have historically performed consistency, knowing that investment ensure full agreement that better than passively managed performance will not vary greatly from the manager is an acceptable investments when the markets are the benchmark. Before making a investment option decidedly negative, or in flat to moderate decision, it is important to consider your 6. Ongoing due diligence used markets. Conversely, passive investments expected time horizon, tax sensitivity, to assess consistency among have generally outperformed in swiftly ability to tolerate performance variation people, process, philosophy rising markets. While there are and other factors. Your Financial Advisor and performance exceptions to these dynamics, can help you weigh your objectives and Although it is easy for investors to understanding when market conditions concerns to determine which approach is access historical performance data, are favorable or unfavorable for an most appropriate for you. deeper information becomes much investment style is important in more difficult to uncover. A robust managing expectations. 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 and trade on an exchange throughout the day. 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.