the case for passive investing - etf webinar

8/9/2019 The Case for Passive Investing - ETF webinar

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2010, Morningstar, Inc. All rights reserved.

The Case for Passive Investing

Ben Johnson

ETF Strategist

Bradley KayAssociate Director, ETF Research

April 2010


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Todays Agenda

Purpose: We will use our time today to discuss the case for passive investing.

We are not looking to declare a winner in the battle between active and passive management, we

are simply going to examine the body of theory and evidence around it.

William Sharpes argument for passive investing

Searching for alpha among active strategies

Are good managers just lucky, or do they keep beating the market?

When active management might have better odds

How career risk and tracking error can hurt the performance of active investments

Are fixed income markets different?

Conclusion

Discussion


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William Sharpes Argument for Passive Investing

In the Arithmetic of Active Management, William Sharpe puts forth anelegant argument that builds the case for passive management.

Sharpes basic premise is as follows:

If "active" and "passive" management styles are defined insensible ways, it mustbe the case that:

(1) before costs, the return on the average actively manageddollar will equal the return on the average passivelymanaged dollar and

(2) after costs, the return on the average actively managed dollarwill be less than the return on the average passivelymanaged dollar

These assertions will hold foranytime period. Moreover, they depend onlyon the laws of addition, subtraction, multiplication and division. Nothing else isrequired.


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William Sharpes Argument for Passive Investing

The cost of active management

If, on average, active and passive strategies yield identical pre-

expense returns then expenses become a crucial consideration

Passive management is inherently less costly

Average expense ratios:

European ETFs 35 basis points

Open End European Equity Index Funds 91 basis points

Actively Managed European Equity Funds 180 basis

points


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Searching for Alpha Among Active Strategies

Over any given period, there will be a portion of active managers that

generate alpha.

Remember, Sharpes argument describes average returns.

So active managers will by definition have equal odds of generating returns

that lie on either side of the market average/benchmark return in question.

Lets take a closer look at some of the studies of active managers ability to

generate alpha.


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Luck versus Skill in the Cross Section of Mutual Fund Returns

Fama and Frenchs studyoriginally published in 2007examined actively managed

U.S. mutual funds for the period from 1984 to 2006.

Their work supports Sharpes argument:

Aggregate alpha before expenses = 0

Aggregate post-expense alpha is negative in proportion to the total amount

of fund expenses

They also find that it is difficult to distinguish between the role of skill and luck in

generating alpha.

Specifically, their findings could not distinguish between true stock-picking skill and

chance in explaining persistent outperformance.


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An Empirical Investigation into the Performance of UK Pension Fund

Managers

Clare, Cuthberson, and Nitzsche took an in-depth look at the UKs defined

benefit pensions industry to gauge the ability of managers of pooled

investment vehicles to generate alpha.

A summary of their findings:

Using data on 734 pooled funds, that had a combined value of just over400bn at the end of 2007, ranging from UK equity to funds specialising inPacific Basin equities, we found almost no statistically significant evidencethat the managers of these funds generate alpha, or can time the market.

First, using a range of different methodologies and tests we find littleevidence of positive performance persistence.

The implication of this result is that pension schemes may be better off inthe long-term investing in passive investment vehicles with their lowerassociated fees than in their active equivalents. That is, investing toachieve beta and not paying for alpha which seems illusive.


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Are Good Managers Just Lucky, or do They Keep Beating the

Market?

While many managers may best their benchmark in a given period,

evidence shows that outperformance is rarely persistent and often attributable

to momentum.

In On Persistence in Mutual Fund Performance, Carhart finds that funds

generating superior one-year returns outperform by virtue of holding largepositions in last years best performing shares, not by manner of superior

management.

Carharts work shows that while the performance rankings of some top-

performing and many of the worst-performing funds exhibit some persistence,the year-to-year rankings of most funds is largely random.

Carhart also finds that returns show a strong negative relationship to fund

loads, fees, and turnover.


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Additional Evidence of the Lack of Persistence in Dutch Pension

Funds

In Performance Persistence of Dutch Pension Funds, Huang and Mahieu

studied the performance of Dutch pension funds relative to their benchmarks

and the persistence of these funds performance.

The pair found that the group as a whole could not best its self-selected

benchmarks.

Much like Carhart, they find no evidence of performance persistence.

They conclude that the migration of funds between the top-, mid-, and

bottom-performing portfolios is near-random.


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When Active Management Might Have Better Odds

Again, by definition active management will succeed about 50% of the time.

Remember however that persistent alpha is difficult to find, the same

manager is extremely unlikely to succeed in beating their benchmark on a

regular basis.

Studies on Active Share have shown that active management is more

successful than the data might tell.

However, bending to institutional pressures, many managers stray from a

concentrated portfolio of their best ideas in order to soothe investorconcerns and reduce risk (for both their portfolios and their own careers) and

tracking error.


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Active Share

In How Active Is Your Fund Manager? A New Measure That PredictsPerformance, Cremers and Petajisto introduce the concept of activesharethe portion of a fund portfolios holdings that differ from the fundsbenchmark holdings.

The pair finds that the funds with the highest active share not only

outperform their benchmarks on a post-expense basis, but they also showstrong performance persistence.

So why dont more active managers seek to increase their active share?


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Best Ideas

In Best Ideas, Cohen, Polk and Silli examine the performance of stocks

that represent active managers best ideas

Their work finds that active managers highest conviction stock picks tend

to outperform the broader market.

However, the other shares that these managers hold do not exhibit similar

outperformance.

These remaining ideas typically add no alpha at all, but there are incentives

to include them nonetheless.


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Best Ideas

Adding more, lower-conviction names reduces volatility, price impact,

illiquidity, and regulatory and litigation risk.

Increasing the number of holdings also allows managers to take in

additional assets, thereby growing fees.

While the incentives for managers to dilute their best ideas are clear,

investors are made worse off.

The authors conclude that investors would benefit from managers holding

more concentrated portfolios.


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Career Risk, Tracking Error, and the Performance of Active

Investments

There are a number of exogenous institutional pressures that are

commonly cited for shackling active managers.

Active managers that fail to beat (or at least approximate) their

benchmarks returns will inevitably face the wrath of their investor base.

In order to minimise tracking error, many active managers have become

closet indexers, dabbling minimally in unique ideas and otherwise looking to

mimic benchmark returns.


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How Active Management Can Succeed

Some of the more successful active equity managers:

Run concentrated portfolios of their best ideas

Are not afraid to hold cash (which inherently increases tracking

error)

Have low turnover

Keep costs low

Example: Fairholmes Bruce Berkowitz Morningstars U.S. Equity

Fund Manager of the Decade


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Are Fixed Income Markets Different?

Fixed income markets are often cited as an area where active management

is more likely to add value.

Fixed income markets are characterised by a high level of institutional

friction:

Bond investors often face ratings restrictions which inherently limit

their investable opportunities.

Capitalisation-weighted fixed income indices will tend to

overweight government debt or the obligations of highly leveragedfirms.

These structural inefficiencies are exploitable by active managers that are

able to operate free of ratings-related or other restrictions.


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Conclusions

When comparing average post-expense returns to active and passive

strategies, there is a strong case to be made for passive management.

The case for passive management is perhaps strongest in larger, more

efficient markets, like those for large capitalisation equities.

Active managers can and do generate alpha, sometimes.


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Conclusions

On average, the persistence of alpha is weak.

Institutional pressures can limit managers willingness and ability to run

concentrated portfolios consisting solely of their best ideas.

Low cost, passive investments like ETFs offer an attractive compliment to

active management.


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Works Cited

The Arithmetic of Active Management - William Sharpe (1991)

Luck versus Skill in the Cross Section of Mutual Fund Returns - Eugene F. Fama and Kenneth

R. French (2007)

An Empirical Investigation into the Performance of UK Pension Fund Managers - Andrew Clare,

Keith Cuthbertson, and Dirk Nitzsche (2009)

On Persistence in Mutual Fund Performance - Mark M. Carhart (1997)

Performance Persistence of Dutch Pension Funds - Xiohong Huang and Ronald Mahieu (2008)

How Active is your Fund Manager? A New Measure that Predicts Performance. - K.J. MartijnCremers and Antti Petajisto (2009)

Best Ideas Randy Cohen, Christopher Polk, and Bernard Silli (2005)


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Further Reading

"Mutual Fund Performance: An Empirical Decomposition into Stock-Picking

Talent, Style, Transactions Costs, and Expenses - Russ Wermers (2000)

"Performance Attribution of US Institutional Investors - Murat Binay (2005)

"Measuring Mutual Fund Performance with Characteristic-Based

Benchmarks - Daniel, Grinblatt, Titman, and Wermers (1997)


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Discussion

We would now like to open the call to our audience for a question and

answer period.

You can pose your question or share your comments over the phone by

following the conference operators instructions.

Alternatively, you can submit written questions or comments to us using the

Q&A function on the Live Meeting portal.

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