Endowment Management and the Benefits of Active Investing The question of active-versus-passive investing is a compelling debate for many fiduciaries of investment capital. Within this paper, we answer three key questions: 1) Why active management? 2) Why active management now? 3) Why a dedicated research team? The research suggests that alpha exists in the long run but is cyclical in the short run, and that we may be in a favorable part of the cycle for active management. We also emphasize the important role of alpha in helping an endowment portfolio meet its return target in a risk-controlled way.
Active management rests on the belief that alpha (idiosyncratic and uncorrelated value-add) can be generated.
1 Introduction The question of active-versus-passive investing is once again challenging fiduciaries of investment capital. As many active managers have failed to outperform passive products during the recent equity bull market and flows into passive vehicles have dramatically increased, investment committees are re-examining the role of active managers relative to passive investments. We address this issue by revisiting some foundational tenets of long-term investing. Note that this paper is not meant to be a comprehensive comparison of active and passive investing; rather, we present a framework for the philosophy underpinning active management and show how it can benefit investors. Active management rests on the belief that alpha (idiosyncratic and uncorrelated value-add) can be generated. In our analysis of the benefits of active management, we focus on the history and near-term future of alpha. We present empirical evidence demonstrating that alpha generation does exist and plays a meaningful role in the risk/return profile of a long-term portfolio. We also evaluate the longterm cyclicality of alpha and use current market dynamics to explain why we believe that this is a particularly appropriate time for active management. The question of active-versus-passive investing is once again challenging fiduciaries of investment capital.
2 Alpha Exists in the Long Run We first take a step back from the discourse about recent market trends to look at the longer-term picture of investment performance. Lengthening the time frame to include multiple market cycles, we observe that active management has delivered meaningful alpha in the past. Figure 1 displays the 10-year annualized performance of a subset of endowments with over $1 billion in assets that report to the National Association of College and University Business Officers (NACUBO). These large endowments tend to be professionally managed, diversified across various asset classes, and heavily invested in active managers. These endowments have also handily outperformed the two most prevalent passive equity/fixed-income benchmarks over the long term. Figure 1: Long-Term Alpha of Endowment-Style Investing Trailing 10-Year Annual Returns Portfolio As of FY 2016 As of FY 70% MSCI ACWI / 30% Barclays US Aggregate 4.9% 6.2% 60% MSCI ACWI / 40% Barclays US Aggregate 5.1% 6.1% Endowments > $1 billion in AUM (NACUBO) 5.7% 7.2% This data from actual net-of-fee endowment performance is evidence that endowment-style investing has added significant value in the past. The outperformance is meaningful by itself, but compounded over time leads to more substantial portfolio growth compared with the passive benchmarks. We believe a significant portion of this alpha generation has come from investing in active managers that are exceptionally skilled in security selection, but we also acknowledge that broader factors such as diversification benefits and illiquidity premium play a role in any side-by-side comparison. Still, we use this endowment data as empirical proof of the existence of alpha over pure liquid, indexed investment strategies and as necessary long-term context to anchor the debate. Lengthening the time frame to include multiple market cycles, we observe that active management has delivered meaningful alpha in the past
3 In order to isolate the equity side of the story, we look beyond the NACUBO data to the long-term equity performance of stock pickers as defined by the Goldman Sachs Hedge Fund VIP lists. 1 Looking at Figure 2 (left), we see that the most prevalent long (short) positions of hedge fund managers have meaningfully outperformed (underperformed) the S&P 500 over a 15-year period. This finding indicates that extensive company research and deep analysis of opportunities by high-quality active managers can identify both undervalued and overvalued securities in the market over long periods of time. Figure 2: Long-Term Alpha of Hedge Fund Managers GS HF VIP VS. S&P 500 400 SPX 350 VIP Long 300 VIP Short 250 200 150 100 50 0 2001 02 03 04 05 06 07 08 09 10 11 12 13 14 15 2016 Rolling Two-Year Return (%) GS HF VIP LONG SPX 35 30 25 20 15 10 5 0 5 10 15 2003 04 05 06 07 08 09 10 11 12 13 14 15 2016 When we chart the rolling 2-year performance of the hedge fund VIP longs minus the S&P 500 (Figure 2, right), we observe the overall trend of outperformance very clearly. Just as with many other factors relating to the business cycle, active management underperforms in a few short-term periods. The last couple of years have been one of the worst periods in terms of underperformance, but we believe that this trend will revert to the mean as it has before. We then compile databases of active managers and compare them with their benchmarks to expose interesting trends across investment universes. 2 Starting with the United States, active managers in the U.S. large-cap category have most meaningfully lagged their benchmark over the past few years (Figure 3, left). The longer-term charts in Figure 3 display the cyclicality that has also existed in this peer group since 1985, and they further contextualize our current moment in the cycle (situating us at what is perhaps an inflection point). We also observe that the majority of managers in this universe have not routinely provided compelling excess returns versus the S&P 500.
4 One prevalent hypothesis that is often cited in the active-versus-passive debate is the steady growth in the number of active managers who have crowded the space, thereby squeezing the opportunity set. One can see this growth in Figure 3, and it has indeed been steady (although the number is starting to retreat). We believe that this underscores two key points about manager selection: (1) it is important to note (even at the lowest points) that at least 10% of the universe still outperformed, and (2) while a dedicated staff of research experts is required to find these managers, it is possible as there are a larger number of funds in the top percentiles. In Figure 3 (right), using the same data we group excess returns into quartiles to observe the importance of manager selection and find a meaningful spread between top-quartile and median managers. Interestingly, though, even these top-quartile managers experience short-term periods of underperformance (see the periods where the top-quartile line dips below the 0% axis). Figure 3: Performance of Active Managers in the U.S. Large-Cap Universe PERCENTAGE OF U.S. LARGE-CAP ACTIVE FUNDS U.S. LARGE-CAP ACTIVE FUNDS ROLLING 5-YEAR OUTPERFORMING S&P 500 (5-YEAR ROLLING BASIS) ANNUAL EXCESS RETURN VS. S&P 500 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% % Outperforming # of Active Funds (Right Axis) 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2006 2008 2010 2012 2014 2016 1000 900 800 700 600 500 400 300 200 100 0 12% 10% 8% 6% 4% 2% 0% 2% 6%- 4%- Median Top Quartile 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2006 2008 2010 2012 2014 2016 The headline of manager underperformance in the U.S. large-cap peer group seems to be the most cited evidence in favor of passive investments. It is important, though, not to generalize this to all active managers, particularly across different investment universes. Looking across geographies, we find less efficient markets that provide more attractive environments for alpha generation, and indeed active equity managers in the international and emerging markets have demonstrated a sustained ability to outpace their benchmarks (Figure 4). In these markets, returngenerating opportunities are often within smaller-capitalization stocks; it is particularly beneficial to invest with active managers who can manage the liquidity risk inherent in investing in this space. Looking at the quartile returns, it is clear
5 Looking across geographies, we find less efficient markets that provide more attractive environments for alpha generation. that even the median manager has routinely outperformed the benchmark, and the top-quartile managers have done so by a meaningful margin. Although this data provides a compelling counterpoint to the U.S. large-cap graphs, the interesting trend of return compression continues within these markets, albeit to a lesser degree. Perhaps the coincident growth in the number of active funds is gradually making these markets a little more efficient as well. Regardless, the data shows that the top half of the active manager universe in these markets has delivered steady excess returns; we believe that investors with the skill to pick top managers will continue to enjoy this general trend of outperformance. Figure 4: Performance of Active Managers in EAFE and EM PERCENTAGE OF EAFE ACTIVE FUNDS OUTPERFORMING MSCI EAFE INDEX ON A 5-YEAR ROLLING BASIS PERCENTAGE OF EM ACTIVE FUNDS OUTPERFORMING MSCI EM INDEX ON A 5-YEAR ROLLING BASIS 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% EAFE % Outperforming EAFE # of Active Funds (Right Axis) 400 350 300 250 200 150 100 50 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% EM % Outperforming EM # of Active Funds (Right Axis) 350 300 250 200 150 100 50 0% 2000 2001 2002 2003 2004 2006 2008 2010 2012 2014 2016 2017 0 0% 2004 2006 2008 2010 2012 2014 2016 0 EAFE ACTIVE FUNDS ROLLING 5-YEAR ANNUAL EXCESS RETURN VS. MSCI EAFE INDEX EM ACTIVE FUNDS ROLLING 5-YEAR ANNUAL EXCESS RETURN VS. MSCI EM INDEX 12% 8% 10% 8% 6% 4% 2% 0% 2% Median Top Quartile 7% 6% 5% 4% 3% 2% 1% 0% Median Top Quartile 4% 2000 2001 2002 2003 2004 2006 2008 2010 2012 2014 2016 2017 1% 2004 2006 2008 2010 2012 2014 2016
6 Alpha Is Important Simply put, not only is there strong evidence that alpha exists, but that it also plays a key role in a long-term portfolio. Clearly, alpha is an idiosyncratic return driver and can help a portfolio grow over time. But the uncorrelated value-add is also extremely important for achieving the target return for an endowment, while keeping market/systematic risk at a desired level. Specifically, it allows a portfolio to take less market risk to achieve a target rate of return. This is critical to endowment portfolios, which have a dual mandate of achieving a high real rate of return without large drawdowns that might have a disruptive impact on an institution s spending. Our previous research based on Monte Carlo simulation illustrates the important role of alpha (Figure 5). We look at typical policy portfolios across different equity/ bond/real asset weightings. First, despite having similar long-term risk profiles (i.e., the probability of losing real value in the long term), the 40/50/10 equity/bond/ real asset portfolio, with 1% alpha, has much less annual drawdown risk than the 80/10/10 portfolio with 0% alpha. This is because the former relies upon higher, consistent alpha contributions to returns compared with the latter, which relies upon a higher allocation to risk assets, such as equity, which are much more volatile. Adding alpha through active management significantly reduces long-term risk as well, while keeping short-term drawdown at the desired level. In a typical policy portfolio of 60/30/10 equities/bonds/real assets, the probability of losing real value in the long term is reduced by more than 10% for every 1% increase in alpha, while maintaining the same short-term drawdown risk profile. The uncorrelated value-add is extremely important for achieving the target return for an endowment, while keeping market/systematic risk at a desired level. Specifically, it allows a portfolio to take less market risk to achieve a target rate of return.
7 Figure 5: Risk Trade-Off for Different Alpha Levels SHORT-TERM (1 YR) AND LONG-TERM (10 YR) RISK TRADE-OFF EQUITIES/BONDS/REAL ASSETS 5% SPENDING WITH DIFFERENT ALPHA 0% Short-Term Risk 1% Annual Tail Risk 5% 10% 15% 20% 25% 30% α = 2% α = 1% α = 0% α = 1% 10/80/10 20/70/10 30/60/10 40/50/10 50/40/10 60/30/10 70/20/10 80/10/10 35% 90/0/10 20% 30% 40% 50% 60% 70% 80% 90% 100% It is important to remember the idiosyncratic and uncorrelated nature of alpha, which serves as both an absolute return driver and a risk mitigation tool. Sacrificing alpha in the pursuit of higher beta will introduce more market risk to the portfolio and may cause unintended structural impairment over the short and long run. Indexed Exposure Can Be Problematic Passive vehicles provide unconstrained beta exposure that can present problems in certain environments. Investing through an index can be viewed as a de facto subtle momentum strategy, with the increased capital flows inflating the very index to which it is allocated. When the index is market-capitalization based, it can mean buying increasingly expensive companies and sectors, thereby participating in both bubbles and market corrections. A prominent example of this phenomenon is the evolving weight of the Information Technology sector within the S&P 500 Index (Figure 6, left). The index s exposure to the sector peaked to almost a third before the 2001 tech bubble burst, thus leading to rapid value destruction that took years to rebuild with a passive strategy. Although passive investing is an effective way to capture market upside, it is also equally effective at capturing the full
8 downside. The drawback of market-cap weighting is also observed with the MSCI Emerging Markets (EM) Index (Figure 6, right), which is overweight large-cap state-owned companies in low-growth sectors, and as such does not holistically reflect the expansive opportunity and diversification benefits of investing in EM. As market-cap weighted indices tend to be backward looking (biased toward those companies that have done well in the past), they are at a particular structural disadvantage in such a quickly evolving, variegated space like Emerging Markets. The benefit of active investing in these geographies is that investors can place capital in specific sectors and companies that stand to gain the most from local economic development (such as consumer-oriented companies and healthcare). Figure 6: Examples of the Impact of Market-Cap Weighting on Passive Indices S&P 500 INFO TECH SECTOR WEIGHT MSCI EM SECTOR EXPOSURES 35 30 Utilities 3% Real Estate 3% Health Care 2% 25 20 15 10 5 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2006 2008 2010 2012 2014 2016 Tel SVC 6% Industrial 6% Energy 7% Con Stpl 7% Material 7% Cons Dis 10% Info Tech 25% Finance 24% In general, active management has the often hidden advantage over passive approaches of providing rational limits to company-, sector-, and industry-level concentration. This extra layer of analysis and prudence can provide compelling downside mitigation benefits in certain environments, without a loss of return-generation capabilities. There are structural complications with passive fixed income investments.
9 Active-versus-passive is most often debated in terms of equities, but fixed income is also attracting a growing number of passive investors. However, there are structural complications with passive fixed income investments. Currently, many global fixed income indices have considerable exposures to zero and negative interest rate policy countries ( ZIRP and NIRP ). Looking at the Barclays Global Aggregate index (Figure 7), we see that market-cap-based weights mean that the more that a country is in debt, the higher its weight is in the index. This is a counterintuitive way of constructing an investment portfolio. It is particularly difficult to invest this way in today s quantitative easing (QE) dominated market environment, in which the largest issuers of debt embrace ZIRP and NIRP. An active fixed-income management approach allows for underweighting exposure to prolific issuing countries following ZIRP and NIRP, and selectively overweighting countries that have more manageable levels of debt and potentially higher real yields. We believe this is a more rational investment approach that reduces portfolio risk over time. Figure 7: Barclays Global Aggregate Real Yield vs. Market Capitalization Weights REAL YIELDS VS. MARKET CAP WEIGHTS 45 40 35 30 Real Yield Weights in Global Agg 25 20 15 10 5 0 5 Brazil Greece Russian Federation India South Africa China Thailand Portugal Mexico Poland Singapore Taiwan, Province of China Australia Italy Saudi Arabia Korea, Republic of Ireland Canada United States Japan France Denmark Sweden Switzerland Norway Spain United Kingdom Germany
10 Why Active Management Now As we ve demonstrated, active management alpha is typically cyclical, and many of the charts in this paper indicate that we may have just exited from a significant trough. Qualitatively, we believe the market factors that posed difficulty for active management over the most recent period are dissipating and that we are now in a particularly compelling part of the cycle for alpha generation. There are a few factors driving this outlook: 1. Divergent central bank policies and economic outlooks. At a high level, we believe that we are returning to an environment that is less macro/qe-driven, in which idiosyncratic stock characteristics will drive returns in the U.S. and internationally. 2. Interest rate normalization and increasing dispersion between individual stocks and sectors. As interest rates continue to rise and the availability of cheap leverage begins to abate, we anticipate more dispersion between the performance of good and bad companies. A return to a more normalized interest rate and monetary environment thereby tends to be advantageous for active managers seeking to select fundamentally stronger companies that can outperform the benchmark which would have exposure to both good and bad companies. 3. Massive inflow to passive products. These passive inflows have helped push up equity market valuations to rich territory for index participants. While it is difficult to predict the sustainability of these valuations, being nimble and a little off-the-run at this point in the market cycle seems like a prudent way to help uncover undervalued securities and potentially protect capital in the event that flows reverse. We believe there are attractive long-term investment opportunities in companies that are not included in the index or where such companies have a very small weighting due to market capitalization. We believe the market factors that posed difficulty for active management over the most recent period are dissipating and that we are now in a particularly compelling part of the cycle for alpha generation.
11 4. Rich equity valuations. As discussed, these passive inflows have helped inflate equity market valuations in general to high-priced territory. The CAPE ratios (Figure 8, left) also show the relative expensiveness of the U.S. versus EAFE and EM, which reinforces the importance of a truly global portfolio that can take advantage of global trends. As we have discussed, active managers have had much more success in the EAFE and EM geographies than their passive counterparts. 5. Extremely low equity volatility. Domestic equity volatility has been at historic lows during this market run-up. We expect volatility to follow its mean-reverting trend (Figure 8, right) and to increase in the future. This increased volatility will provide active managers with opportunities to increase exposure to high-conviction holdings from market movements and to try to minimize downside capture. Figure 8: Current Market Environment GLOBAL CYCLICALLY ADJUSTED PRICE/EARNINGS (CAPE RATIO) 50 MSCI ACWI 45 S&P 500 40 MSCI EAFE 35 MSCI EM 30 25 20 15 S&P 500 ROLLING 1-YEAR VOLATILITY 50% 45% 40% 35% 30% 25% 20% 15% 10 10% 5 5% 0 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2006 2008 2010 2012 2014 2016 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2017
12 A Note on When to Invest Passively It is important to note that passive investments can play a role in a portfolio and that the solution does not have to be entirely binary. Passive instruments can be used selectively and actively to buttress a portfolio in a variety of ways. We typically incorporate small passive investments to facilitate liquidity, to maintain geographic exposure while rotating in/out of managers, and to get exposure to assets where we have not yet found a compelling active manager. In these ways, we believe certain passive investments can serve as beneficial short-term vehicles to promote balance and fluidity in a portfolio. We also note that institutions without a full-time staff or partner with demonstrated manager selection skill may be better served allocating a meaningful portion of their capital to passive indices, as long as the limitations are understood. A considerable spread exists in all the Passive instruments can be used selectively and actively to buttress a portfolio in a variety of ways. active manager universes, and third- and fourth-quartile managers can potentially do more harm to portfolio growth than index investing. For these institutions, it is important to understand that even in allocating to passive investments, important active portfolio construction decisions need to be made: which specific indices to allocate to (across geographies, market capitalizations, sectors, etc.), the timing of market entry, when to rebalance, what to adjust during sector bubbles, among others. The simple but crucial point is that active decision making and monitoring are required regardless of investing entirely in active managers, entirely in passive indices, or in some combination of the two.
13 Conclusion We caution investors from over-reacting to recent market dynamics by turning away from the active approach that has been a cornerstone of providing excess returns in the endowment world for a very long time. We believe an endowment can meaningfully outperform passive benchmarks and, importantly, reduce portfolio risk over time by investing with high-quality active managers. However, doing so now does require very strong manager selection capabilities; we believe those institutions with teams that have the expertise and resources to select high-performing active managers will benefit most in the long run. Given an endowment s perpetual time horizon, high risk tolerance, and low liquidity needs, we believe they are particularly well suited for the typical profile of the most successful active managers. These active managers typically (1) conduct extensive original research and thereby tend to run concentrated portfolios resulting in high tracking error to the benchmark, and (2) focus on longer time horizons than their more benchmark-hugging active counterparts (i.e., closet indexers). Not only do these characteristics correspond well with the average endowment risk appetite, but also we believe they are the key components required for long-term success. Simply put, active management across most asset classes is one tangible way that an endowment can capitalize on its unique risk tolerance, liquidity profile, and time horizon to create excess returns. This has been beneficial to many endowments in the past, but we believe it to be particularly applicable in the current market environment. Endnotes 1 The GS HF VIP Long list equal weights the top 50 securities that most often appear on the 13F filing among the top 10 holdings of hedge funds and other institutional investors. The GS HF Short list is an equal-weighted basket that consists of 50 S&P 500 constituents with the highest total dollar value of short interest outstanding. 2 The evestments database is the most extensive data source for hedge funds at this point in time. It includes both mutual funds and hedge fund managers. In an attempt to reduce survivorship bias, we include both live and closed down funds within the historical data. Performance is net of fees.
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