Upload
morningstaruk
View
223
Download
0
Embed Size (px)
Citation preview
8/9/2019 The Case for Passive Investing - ETF webinar
1/21
2010, Morningstar, Inc. All rights reserved.
The Case for Passive Investing
Ben Johnson
ETF Strategist
Bradley KayAssociate Director, ETF Research
April 2010
8/9/2019 The Case for Passive Investing - ETF webinar
2/21
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
8/9/2019 The Case for Passive Investing - ETF webinar
3/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
4/21
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
8/9/2019 The Case for Passive Investing - ETF webinar
5/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
6/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
7/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
8/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
9/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
10/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
11/21
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?
8/9/2019 The Case for Passive Investing - ETF webinar
12/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
13/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
14/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
15/21
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
8/9/2019 The Case for Passive Investing - ETF webinar
16/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
17/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
18/21
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.
8/9/2019 The Case for Passive Investing - ETF webinar
19/21
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)
8/9/2019 The Case for Passive Investing - ETF webinar
20/21
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)
8/9/2019 The Case for Passive Investing - ETF webinar
21/21
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.