Active & Passive: A Harmonious Combination

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1 Throughout our history, GenSpring has utilized a combination of both active and passive investment solutions to solve for client needs. During this time, we have always been confounded by the ongoing debates between the staunch supporters of each side. Perhaps it is our role as an advisor that enables us to take a more objective approach on this issue as we have dealt with distinct client preferences which have required solutions on both sides of the aisle. From an advisory perspective, we have found that active solutions are more effective for solving certain objectives, while passive ones are the clear winners when solving for others. Nevertheless, the debate will rage on, and we thought a bit of perspective on how we see the landscape would be instructive. Passive investing, or Index Replication, as it is also known, relies on the efficient market hypothesis ( EMH, which assumes that all information is quickly and accurately reflected in securities prices) to tout the benefits of lower costs (see Figure 1.1) and increased tax efficiency as distinguishing characteristics and advantages over active investing. These advantages are compelling, yet investors would Expense Ratios (Weighted Average) Figure 1.1 Source: Barron s be wise to not ignore several hidden costs associated with passive investments. Because of the investment expense of these securities, replication vehicles should be expected to underperform their relevant benchmark, albeit quite modestly, and yet will be subject to the full force of market declines when they arise. Furthermore, because these solutions are mandated to track an index, they also bear the hidden Sustaining Family Wealth

2 cost of reconstitution, which is a fancy way of saying that the fund is forced to purchase and sell securities when changes to the index are announced. For most investors, it may come as a surprise that research has found that reconstitution has been estimated to cost up to 2% per annum. Figure 2.1 illustrates the impact reconstitution has on the price of the index. Illustration of Reconstitution Impact opportunity. These arguments are hard to argue with and very difficult to overcome if not thoroughly researched and diligenced. The paradox in all of this is if active management did not exist, then a key assumption of the EMH would be invalid, rendering markets inefficient. So in theory and in practice, passive needs active and active needs passive. An Alliance Bernstein report on the topic puts an exclamation point on this concept by concluding that passive management s equilibrium state is likely close to 35% of industry assets. The explanation is a bit academic but amounts to the notion that underperforming managers tend to go out of business far sooner than outperforming managers, creating a positive tradeoff for investors seeking outperforming managers. One-Day Return after Announcement (%) Run-Up to Effective Date (%) Decay after Effective Date (%) Figure 2.1 S&P 500 Index MSCI EAFE Index Source: Dimensional Fund Advisors GenSpring believes that traditional index replication can be improved through a set of solutions that we call Enhanced Indexing or Factor Replication. These solutions improve upon the value proposition of indexing by avoiding the cost of reconstitution and in some cases actively target improved tax efficiency. Figure 2.2 compares the advantages and disadvantages of the three broad categories. Active investing presumes that several assumptions made in the EMH are invalid, and that value can be added by actively seeking information and more appropriately managing risk. Of course these solutions bear higher explicit fees in the form of both management fees or expense ratios and generally reduced tax efficiency. They may also experience significant periods of underperformance relative to a benchmark, which introduces the cost of lost Passive (Index Replication) Quasi Passive (Factor Replication) Active Cost Low Low Higher Tracking Error Low Low/Variable Variable/ Higher Transparency High Variable Variable Potential to Outperform Potential to Protect Capital Figure 2.2 No Yes Yes No Yes Yes Source: GenSpring Family Offices 2

3 Passive Thriving in the Wake of Market Strength Markets have continued to power higher in the wake of the global financial crisis (GFC) of 2008, and the tide appears to be lifting all ships. Opportunities to add value in stock selection have dwindled as correlations among individual stocks have risen to mirror the trend in the exchange traded products (ETP) industry (Figures 3.1 and 3.2). ETP assets have soared to over $2 trillion from less than $300 billion in the last decade, and the average pace of product launches in this passive space in the last 5 years has been 644 per annum, leading to nearly 5,000 ETPs in the marketplace today. Asset flows of this magnitude must have an impact on the demand for the securities that the ETPs are buying. Average Stock Correlation: 3-month Rolling Average Figure 3.1 Source: Factset The structural benefits of ETPs/ETFs (funds) versus standard index mutual funds rendered this shift somewhat inevitable, yet its impact on active security selection has been somewhat surprising. We believe Exchange Traded Products Figure 3.2 Source: Blackrock retail investors have embraced ETPs/ETFs as a way to manage investment expense and tax impact, while institutional investors, including hedge funds, have adopted ETPs particularly for hedging reasons. Like all others, we believe this trend will continue until it ends, and those calling for the death of active management will once again be proven short-sighted. The Search for Active Despite our view that the scales will once again tip in the direction of active, it remains true that the average or median fund tends to have a difficult time outperforming its benchmark. This should not deter an appropriately resourced investor, however, since investing in active strategies provides a relatively low cost option on improved performance. We conducted research utilizing the Morningstar database to better understand what the data says. Our study focused on Large Cap, Small Cap, All Cap, 3

4 International, and Emerging Markets strategies to understand the performance attributes of each strategy cohort. In order to isolate the active variable, we only allowed funds which were coded as active in the database and then calculated the rolling 3-year excess returns (net of fees) for the past 15 years for each fund. The performance data was then sorted by manager over the entire period. This distinction is important since a sort by 3-year period would have yielded improved results since it would lead to higher turnover in the manager list. Perhaps surprisingly, the median manager actually did provide some value after fees, but in most cases, the impact was only slightly positive. This is encouraging and supportive of our view that active can prove to be a low cost option if the manager consistently outperforms. Further, it appears that excess returns are available for investors that employ a due diligence process which is well executed and focused on finding top talent. Of course this is easier said than done, but there are managers who do outperform. As shown in Figure 4.1, the average performance of the top quartile manager by category has materially outperformed both the median manager and benchmark on a 3-year rolling basis. A Wolf or a Sheep in Wolf s Clothing It is interesting to note that some very robust research is supportive of active manager selection, if conducted with the right analytical lens. In their 2002 study entitled How Active is Your Manager? A New Measure that Predicts Performance, authors Martijn Cremers and Antti Petajisto from Yale University identified a significant link between truly active managers and excess returns. Not only was the study useful in Average 3-year Excess Return by Asset Class Figure 4.1 Source: Morningstar Direct and GenSpring Analysis. As of December 31, 2013 highlighting the value add of active managers, it also provided a useful and sensible distinction between what is truly active and what is not, by developing a proprietary measurement called Active Share. 1 While the Active Share research concluded that funds demonstrating active share of 95% or higher have outperformed their benchmarks by about 2.7% before expenses and 1.4% after expenses, it also showed that much of the investment universe is dominated by passive funds, some with higher fees than warranted. In fact, the percentage of funds demonstrating low active share has grown to over 30% of the industry during the past 30 years (see Figure 5.1). GenSpring seeks to identify managers with high active share 2 where the value added by that differentiation is not expected to be consumed by their expense. We 1 Active Share measures the difference in holdings of an investment portfolio relative to its closest index so it has the benefit of segregating managers by how truly different they are from a holdings based perspective rather than a simple statistical one. 2 Detailed discussion of our manager-fund selection process is beyond the scope of this paper. 4

5 The Rise of the Closest Indexers Figure 5.1 Source: Antti Petajisto, Active share and mutual fund performance, Financial Analysts Journal 69:4 (July/August 2013): * Category range from least (0-20%; or pure index funds) to most active (80-100%). Closest indexers consist of 20-60% of active share. have often said that what is most important is the money left in your pocket not the price you pay for performance. Considerations When Selecting Active or Passive As we alluded to earlier, both passive and active solutions have positive attributes and should be used when their advantages are consistent with an investor s goals and objectives. Thus, there are several factors to consider when deciding to allocate to either a passive or active solution. Time Horizon GenSpring believes that a commitment to active managers requires patience to extract expected excess returns. In other words, an investor should not expect an active manager to outperform immediately or even over the first few years. Investors who allocate to active managers should have the discipline to remain invested in these managers for a full market cycle. Studies have shown that this discipline is difficult for most investors to adhere to. According to research by DALBAR, from the S&P 500 returned 13.2% annually while the average stock mutual fund investor 3 earned only 3.7% per year for the same period. The experience of investors was no different in the Fidelity Magellan fund while Peter Lynch was at the helm from Despite strong annualized returns of 29% over this period, Fidelity calculated that the average investor 4 actually lost money in the fund over this period of time. GenSpring judges active manager returns on 3- and 5-year rolling basis, even though we review their performance more frequently. Because we advise individual investors, and not institutions, we are acutely aware of the behavioral biases that plague most investors. Thus, if an investor isn t prepared to hold a particular strategy for at least 3-5 years, the portfolio holding should likely be in the form of a passive solution. Tax Sensitivity Tax efficiency is generally an advantage associated with passive or enhanced indexing. Certain enhanced solutions actually target the harvesting of losses to improve tax efficiency and provide a shelter to future gains. We recommend that clients with particular sensitivity to incurring a tax liability should consider a passive ETF structure or a tax managed vehicle and be very selective about other active trading strategies. 3 DALBAR data based on weighted average fund flows for all equity funds monitored by Lipper 4 Fidelity using weighted average buy/sell data for average shareholder returns 5

6 Investment Fees While passive strategies generally have lower fees than active, the expense differential can vary dramatically. When it comes to ETFs, GenSpring typically analyzes both the stated cost (expense ratio) as well as the bid/ask spread in the market to determine the best solution. Index replication mutual funds or managed accounts can be assessed primarily on their expense ratio or management fee, with the lower being the better. When evaluating active strategies, we believe the sound approach is to understand how much one is paying for non-index exposure. It is imperative to delve deeply into the historical performance of the fund in order to assess the likelihood of outperformance in the future. Successfully investing in active strategies requires a robust due diligence process, focused on the right components. How You Define Risk Risk is truly in the eye of the beholder. Some investors are more sensitive to absolute losses while others are uncomfortable when a particular vehicle underperforms a benchmark it is measured against. Investors worried about experiencing outright losses may find an active strategy managed to reduce downside risk more appropriate, whereas investors who are unnerved by material underperformance versus a benchmark, even if short term, will likely favor passive solutions. Opportunity Set In certain cases, a passive index solution simply doesn t exist or is more difficult to execute. For example, bond indices are quite difficult to truly replicate since there are millions of bond CUSIPs (security identifiers) in issuance. The bond market is heterogeneous as compared to equities. Many fixed income ETFs do a poor job of minimizing tracking error for this exact reason; they simply can t buy all the identical securities in the index. For example, the high yield ETFs JNK and HYG have materially lagged the Citigroup High Yield index since their inceptions, as shown in Figure 6.1. For an ETF this represents a surprisingly high level of underperformance. High Yield ETFs versus the Index Figure 6.1 Source: Pertrac Conclusion For many GenSpring client families, the inclusion of both passive and active vehicles can complement each other and position an investor to achieve his/her goals. The ability to balance the desire for potential outperformance (active) with the consistency of experience delivered by passive solutions does not have to be a decision for a client to choose between. GenSpring is committed to delivering the right mix of both for each client as is consistent with their goals and objectives. Authored by GenSpring Investment Advisory Center 6

7 Disclaimer The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. Investment decisions should always be made based on the investors specific financial needs, objectives, goals, time horizon, and risk tolerance. The statements herein are based upon the opinions of GenSpring and third party sources. Information obtained from third party resources are believed to be reliable but not guaranteed. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time withoutnotice. To know more, please call or visit us on the web at rev