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VIEWPOINTS OCTOBER 2015, ISSUE 2 Our Approach to Equity Investing The ongoing debate between active versus passive management (also called “indexing”) in the context of equity investing may never be fully resolved. While the purpose of this Viewpoints is not an attempt to resolve the debate, we will briefly touch on the differences between these two approaches and the reasoning behind our approach to equity investing. At Houston Trust Company, we believe both approaches have merit, and each may be useful in achieving a given client’s needs and overall portfolio objectives. However, for the vast majority of our clients, we believe core holdings of high-quality, individual stocks managed (at reasonable cost) by independent, third party investment professionals offers a greater degree of flexibility, control and transparency, and can deliver competitive returns over long periods of time with lower volatility than passively managed index mutual funds. Indexing and Active Equity Active equity management, in contrast to indexing, Management Defined seeks to exploit perceived market inefficiencies in an attempt to outperform the underlying index, or In theory, passive equity investing entails simply benchmark, over time. The degree of outperformance replicating the holdings in an underlying index by is commonly referred to as a manager’s “alpha” purchasing the same securities in the same weights (i.e. the value-added return in excess of the appropriate as the index. In practice, however, what the investor benchmark which is attributable to the manager’s actually owns is a financial instrument, the return of skill). In simple terms, long-only active equity which reflects the return of the particular index (S&P managers will attempt to earn positive excess returns 500, EAFE, etc.) that the instrument is designed to by overweighting underpriced securities/industry replicate. This is not necessarily a bad thing, but we sectors while avoiding overpriced securities/industry believe in “knowing what one owns,” and owning sectors. “Active” management includes a wide range of an index fund is fundamentally different than an strategies, from low cost, low turnover to expensive, ownership interest in the underlying businesses trading-oriented approaches. of real operating companies, in our view. Map image courtesy of the University of Texas Libraries, The University of Texas at Austin. 1 Research & commentary Portfolio construction Tax efficiency: A decisive advantage for index funds SUBSCRIBE Get our research & commentary Advantages of Indexing December 26, 2013 E­mail address Low Cost Text size: A A A The low cost nature of passive equity managementKe is,y hini gourhli gview,hts a compelling benefi t that this style of equity SUBMIT Learn more investing has to off er. Management fees for passively managed investment vehicles can be found for less than 10 basis points, which is simply a level (in terms of fees)• "Ta xwhere cost" — tmosthe diffe activerence be managerstween the befo cannotre­tax retu compete.rn of a fund a Fornd its example, MORE RESEARCH & preliquidation after­tax return—is a way1 to gauge a fund's tax efficiency. the chart below, taken from the 2014 Investment Company Institute Fact Book , shows that the average actively COMMENTARY managed equity fund’s expense ratio is approximately• Van sevenguard a ntimesalysis fo uhighernd that, f othanr the 1 5the yea raverages ended O cindextober 31 equity, 2013, th efund’s median tax cost of domestic actively managed stock funds was 27 basis points higher than expense ratio: that of domestic index stock funds. Joe Davis on the markets and the FIGURE 5 6 economy • Some index funds can be tax­Investors,inefficient as w inell, ereturnspecially tforhose paying that seek veryto trac klow Expense Ratios of Actively Managed and Index Funds more narrowly focused benchfees,marks cansuch aexpects those in to the earn mid­ a nad market-levelsmall­cap markets . Vanguard Tax­Exempt Bond Index Basis points, 2000–2013 VIEWPOINTS rate of return with market-level volatility. Fund With upper­income Americans facing tax increases as a result of legislation enacted at the beginning of 2013, it's no Let our research power your client Activelymanagedequityfunds surprise that there's heightened interest in tax­efficient investing. discussions Broad­market index funds and their exchange­traded counterparts (ETFs) may be more tax­efficient than actively Tips for talking to clients: Market Activelymanagedbondfunds Tax Efficiency managed funds. Just as some wayPassivelys of managin gmanaged investments aindexre more funds tax­effic ialsoent tha tendn othe rs, certain types of volatility investments are, by their nature, more tax efficient as well. to have a low degree of turnover in the What makes one mutual fund moreunderlying tax­efficient tha holdingsn another? S ofom etheir releva nsecurities.t factors includ e a portfolio's management ALSO OF INTEREST Indexequityfunds strategy, the turnover or trading strategy, the accounting methodology used, and the activity of the funds' investors. This low turnover also leads to a greater Index funds and the myth of the "tax "One way that a degreefund's tax eofffic taxiency effican b eciency, measure din is wgeneral,ith its 'tax coforst ,'" said Scott Donaldson of trap" Indexbondfunds Vanguard Investment Strategy Group. "Tax cost refers to the before­tax return of a fund minus its passively managed funds when compared preliquidation after­tax return. It represents a very high hurdle for active fund managers to overcome, in to the tax effi ciency of the average actively BROWSE TOPICS Note: Expense ratios are measured as asset-weighted averages. Data exclude mutual funds available as addition to their ongoing fund management expenses." investment choices in variable annuities and mutual funds that invest primarily in other mutual funds. managed fund. A recent Vanguard study Economy & markets Sources: Investment Company Institute and Lipper The illustration behelpslow sho tows aillustrate decisive tax athisdvan tpoint,age for in wherebydex funds: T he median tax cost for index funds (left side, green) was 73 basis points, whereas the median tax cost for actively managed funds they conclude that “The median tax cost Portfolio construction (right side, green) was 100 basis points. Thus, for the funds in the data set, the median tax cost of of domestic actively managed funds was 27 basis points higher than that of domestic index funds.”2 The chart In part, the downward trend in the average expense ratios of bothd indexomest iandc act activelyively man aged funds was 27 basis points higher than that of domestic index funds. The gap can be even ETFs below depicts this diff erence in observed tax effila r gciencyer: Note t hbetweene 277­basis ­activepoint diff erandenc e indexbetwee nfunds the wo rsfromt tax co s1998ts (sh o-w n2013: in blue) of domestic actively managed and managed funds reflects investors’ tendency to buy lower-cost funds Investor demand for index funds. Moreover, the chart shows a much narrower range in tax cost within the index category and that 75% of all Wealth management index funds is disproportionately concentrated in the very lowest-costindex fundsfunds h a Ind a2013, lowe forr ta x cost than that of the median actively managed fund. example,One point 66 percent to keep of index in mind equity fundis that assets not were held in funds with expense ratios that wereall “active”among the managers lowest 10 percent are alike.of all index Some equity funds This phenomenon is not unique toemploy index funds, high however turnover The proportion trading ofstrategies, assets in the lowest-cost actively managed funds isgenerating also high frequent realized short-term gains, while others might take a more tax-effi cient, buy-and-hold approach, generating infrequent tax bills and, generally, long-term capital gains. Some managers are “closet indexers” (charging a higher fee for index-like exposure), while others might construct highly concentrated portfolios. Some active managers charge higher fees, while some do not. Thus, it is important to consider the distinguishing features between diff erent active managers, as the term “active management” comes in many diff erent fl avors. MUTUAL FUND EXPENSES AND FEES 91 Why index funds may have the upper hand 1 Investment Company Institute, “2014 Investment Company Fact Book 54th Edition,” www.icifactbook.org 2 The Vanguard Group, Inc., “Tax Efficiency: A Decisive Advantage for Index Funds,” December 26, 2013 2 Performance There is no denying the research that most active It is interesting to note that the performance equity managers fail to outperform their respective advantage tends to fluctuate, cyclically, between active benchmarks, net of fees, over rolling periods of time. and passive management. This cyclicality is most likely For example, a recent CNN Money article cited, driven by the overall market environment which tends “A staggering 86% of active large-cap fund managers to favor active equity managers in periods of low failed to beat their benchmarks in the last year… correlations within the broader equity market, and Nearly 89% of those fund managers underperformed vice versa for passive indexing. As the charts4 below their benchmarks over the past five years and 82% show, different time periods contain significantly did the same over the last decade.”3 Thus, as these different distributions of excess returns in the VIEWPOINTS statistics suggest, it is quite difficult to pick a manager, large-cap active management universe: ex-ante, who will consistently outperform their respective benchmark over the long term. 3 Egan, Matt, “86% of Investment Managers Stunk in 2014,” CNN Money, March 12, 2015 4 Philips, Kinniry Jr. and Walker, “The Active-Passive Debate: Market Cyclicality and Leadership Volatility.” Vanguard Research, July 2014 3 Furthermore, a recent Vanguard study5 shows that even for the managers who outperform their benchmark over a period of 15 years, 97% underperformed their benchmark in at least 5 years with the majority underperforming forFigure a period 2.

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