Active versus Passive Management September 13 th 2015

Active versus Passive Management September 13 th, 2015 - LAPERS Darren Fournerat, CFA, CAIA Laney Sanders, CFA

Agenda • Defining “Active” and “Passive” for portfolio management • Different approaches for implementation for each tactic • Support for each strategy • Current market dynamics • Smart Beta 2

Portfolio Management Process • Strategic or tactical asset allocation decisions – Allocation to a particular asset class • Implementation – What is the best way to invest in that asset class? – Use Active or Passive approach? 3

Active versus Passive • Active management seeks to outperform a given benchmark – Overweight or underweight securities relative to appropriate benchmark in an attempt to “beat the market” • Passive management simply seeks to gain exposure to a certain market – Does not express investment expectations as to which securities will outperform within that particular market 4

Spectrum of Portfolio Management Active Passive Index Fund Enhanced Indexing / Semi active Long Only Benchmark constrained Long / Short Hedge Funds 5

Passive Management - Indexing • An index fund is a portfolio of securities that is purchased, held and managed in order to match the return and risk characteristics of an index – Two types of index funds include: • Fully Replicated – An index fund that holds every single security in the index, and each position will have approximately the same weight in the fund as in the index • Optimized – An index fund that holds a “representative” sample of securities that is determined by advanced mathematical programming software 6

Passive Management – Indexing • Indexing is the most prevalent approach to passive investing • Attempt to match the performance of a pre-specified benchmark • Began in the 1970 s – Quickly grown to where it is today – U. S. alone has more than $1 trillion in institutional indexed equities • Despite this growth, active management still accounts for the overwhelming majority of equity assets managed 7

Active Management • Seeking to outperform the market • Types of Active management – Almost Passive • Enhanced indexing • Smart Beta – Constrained • Long-only – Unconstrained • Long-Short hedge fund 8

Active Management • Considerations for hiring active managers – Which benchmark is appropriate? – What constraints will be placed on the manager to manage risk? • Exposure limits • Pre-defined sub-asset class ranges • Are they allowed to short and / or use leverage? – What fees do they charge? • Flat management fee? • Performance based fee? 9

Support of Passive Management • After fees, the return of the average actively managed dollar, will be less than the average passively managed dollar* • Limited evidence that performance persistence exists – Makes consistently selecting top active managers very difficult • Time and resources needed for active management *Source - The Arithmetic of Active Management” by William Sharpe 10

Support of Active Management • Market “anomalies” do exist – Size Effect – Value Effect • Modern Portfolio theory / Efficient market hypothesis does not consider “behavioral biases” – Traditional theory assumes all investors act rationally 11

Market Efficiency • An efficient market is one in which asset prices reflect new information rationally and quickly – Less efficient markets usually present greater opportunities for excess return, or “alpha” • Market capitalization • Developed versus emerging • Traditional versus alternative 12

Opportunities for Outperformance 13

Current Market Dynamics • Strong U. S. equity performance recently has made it difficult for active managers – S&P 500 gained nearly 75% for the three-year period ending December 31 st, 2014 – Index finished in the top quartile of Large Cap domestic active managers 14

Current Market Dynamics • Why have active managers struggled? – Active managers target higher quality stocks, in general • In the “risk-on” environment created by quantitative easing in the U. S. , lower-quality stocks managed to outpace better-quality stocks for three years – Active managers keep some cash, or “dry powder, ” to be able to quickly execute opportunities as they present themselves • Cash drag is magnified when returns are high 15

Smart Beta – Growth and Popularity 16

Smart Beta • Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes • Take advantage of perceived systematic biases or inefficiencies in the market – i. e. : size, value, volatility • Claims to offer market-beating returns with a rules based, simplistic, and low cost approach 17

Smart Beta – Growth and Popularity • Key findings of Invesco’s Evolution of Smart Beta ETFs – 1 in 3 (36%) institutional decision makers indicate they are currently using Smart Beta ETFs – 64% of institutions indicate they are likely to increase their use of ETFs over the next three years – Six in ten institutional investors surveyed are now familiar with smart beta ETFs, up from 54% last year – Nearly two-thirds of institutional decision makers expect to increase their use of smart beta ETFs over the next three years 18

Smart Beta – What is holding it back? 19

How “Smart” is Smart Beta? • Smart Beta portfolios are not really passive – Actively betting on certain “factors” to outperform – Decision to not hold cap-weighted index – Must decide weighting and rebalancing rules • Vulnerable to being replicated, overcrowded, and are prime targets for front-running – Most of the common factors are already known by the markets – More transparent than active strategies • Given the same universe, smart beta strategies are not diversifying to traditional cap-weighted indices 20

Wrapping up: Active or Passive • Things to consider: – Market efficiency • Less efficient markets can present an opportunity for active management to outperform – Risk tolerance • Active management will expose you to some level of tracking error (active risk) – Fee tolerance • The more active the strategy, the higher the fees – Staff resources • Hiring and overseeing active managers takes time 21