Active vs. passive management

Deciding whether to manage your fund actively or passively

Alfred Slager

January 25th 2010

Debate matches Kain and Abel

Ideas about active vs. passive

• The discussion more relevant to asset managers than to trustees

• Active, passive management are true investment beliefs and should be treated as such.

• Recent research with Koedijk and Bauer suggests that pension funds achieve higher net returns with active management, but not on a risk adjusted basis, shifting the question back to passive

• Over time, there is no such thing as active vs. passive management: they will converge

Tracing the origins of the debate (1)

Tracing the origins of the debate (2)

40 years later: conflicting messages

• Academic literature shows rationale for both active and passive management

• Returns from active management are difficult to achieve - but not impossible. Costs get in the way

• Returns from active management (alpha) and passive management (beta) show similar (unwanted) characteristics in times of crises

• Perception: glamour is in alpha, beta is commodity

• Focus on active management has left passive management wanting of further development; picked up in recent years

7

So the debate continues…

Active Management Passive Management

Promise: Higher net returns

Promise: lower costs always improve net return

Belief: exploit anomalies by combining skills and investment process

Belief: Efficient Market; and if anomalies ; behavioral finance prevents from exploiting these.

Timing and selection matter

Timing and selection: side issues (Brinson Beehower studies)

Active management is a no-brainer for certain asset classes (real estate, alternatives)

OK, but no bottom up approach

Passive is a losing proposition: after costs, you always end up lower than the benchmark.

Touche.

Reflects true ambition of investment consultant and asset manager?

Reflects true ambition of pension fund trustee?

…also because pension funds and asset managers differ

Pension fund Asset manager

Risk diversification

Risk premiums

Responsible Investments

Goals

Inefficiencies

Active management

Teams and staff

Focus

Impact

Risk man.

Koedijk and Slager (2006, 2008)

Finance & Investments young discipline

• Initial approach the physics way: still mainstream

• Humans get in the way

• No “hard” scientific laws, parameters• Humans are not monotone in their behavior• Humans influence predictions

• We have not yet found a way to reach firm conclusions about the major debates in finance

• Neither should we expect it in the near term• Embedding behavioral finance promising avenue

• We have therefore to articulate the investment beliefs behind the debates and choices.

Every strategy is based on beliefs

•Belief: View on how the financial markets work, usually implicit•It’s a belief because we cannot be sure•Making these beliefs explicit shape better investment policies

•Investment beliefs cover• Financial Markets• Investment Process & Organization• Ethics

“Valuations of stocks revert to the mean over time”

“Investors consistently overreact”

’’Consistently outperforming the financial markets is extremely difficult’’

“Costs are certain, net returns are not”

Theory behind investment belief

•Observes behavior in the financial marketplace;

•Frames why the organization deals with this in a sophisticated way.

•Theoretical basis behind the investment belief.

•What is it about that mechanism

•Is it a structural, repeatable phenomenon

•Describes how the investment belief can be exploited.

•Organization to successfully exploit the investment strategy.

•Links the exploitation of the investment beliefs to performance measures.

EXAMPLE ACTIVE MANAGEMENT STRATEGY

Overreaction Mispricing with information dissemmination

Sell with negative, buy with positive earnings announcement

Trading strategy with short term horizon. Good versus bad news announcements have to be identified.

Investment Belief Theory Investment Strategy Organization

Galileo & Copernicus

FDR ‘32

So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.

Gordon Gekko ‘87

Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures, the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge, has marked the upward surge of mankind and greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the U.S.A.

Obama ‘12

Most things are based on beliefs

• Should be “evidence based”, might not always express consensus and can be downright sobering.

• Are not always appreciated

• Offer perspective

• Might have an ethical dimension

• Should be realistic in terms of expectations

2010 Research project for ICPM

• What (implicit) beliefs are behind investment choices made by a pension funds?

• What beliefs really matter?

• What relationship is there between investment choices and performance?

Working with the CEM database

• 219 pension funds• 3.600 billion US dollar• 1992-2007

# Funds Avg. Assets

201 17 billion

# Funds Avg. Assets

14 61 billion

# Funds Avg. Assets

4 13 billion

Method

• Step 1

> Find indicators as proxy for the individual investment beliefs

> Rank portfolios based on indicator – do we observe an effect on performance measures?

• Step 2

> Combine all indicators in one analysis (panel data) to account for interaction – how are results influenced?

Investment debates and beliefs

EFFECT ON

Debate Stylized Investment belief Net return Return/risk

1. Investment Horizon

Longer horizon = earning risk premiums ✓ 0

2. Diversification Diversification is the only “free lunch”0 ✓✓

3. Active – Passive

Funds can create additional net return with active management ✓ 0

4. Costs Costs are a certain drawndown on returns

✓✓ ✓✓

5. Internal-External Management

Combining internal- and external management lowers costs and lowers principal agent issues

✓ ✓

6. Innovation Profit from first mover advantages by investing early in alternative asset classes or new strategies

? ?

Impact of investment beliefs

Costs

Diversification

Active

Managem

ent

Alternatives

Internal M

anagement

Horizon

Impact onperformance

Evidence based investing

• Some investment beliefs are no-brainers for a pension fund:

> Lowering costs> Improving diversification

• Some investment beliefs require a stronger conviction / argumentation why they should be included:

> Alternatives > Active Management

Relevance to active-passive debate

• Governance approach

> Passive base case. Start investment philosophy debate with diversification and low costs

> Next discussion what the fund expects from active management, why, and if they able to implement the strategies succesfully.

• Trendwatching:

> Raise bar to include active strategies• Discussion based on investment beliefs, if they’re valid and

practical> Improve quality of passive strategies

• More research will be spent on improving diversification instead of finding the next anomaly.

> Fundamental indexing> Low volatility strategies

Checklist

Role Relevance to Active vs. passive management

Board of trustees•Clear defined set of investment beliefs?•Agree on consequences for investment strategy and organisation?•Prepared to share and communicate?

•What do we expect from active management?•What do we expect from passive management?•Is this debate relevant for us?•What skills & resources can we organize to create above normal returns with active management?

Investment committee•Aware of its own beliefs?•Beliefs shared with external managers and investment consultants•Evaluation & learning cycle in place?•Able to say no with this set of beliefs?

•Is the IC aware of the beliefs held by the consultant hired to do the selection & monitoring process?•Does the IC challenge the external managers’ beliefs as part of a review ? •Is the IC able to challenge the beliefs?

Questions? Background info

www.investmentbeliefs.org

Koedijk, Kees C. G., Slager, Alfred and Bauer, Rob,

Investment Beliefs that Matter: New Insights into the Value Drivers of Pension Funds (May 8, 2010).

Available at SSRN: http://ssrn.com/abstract=1603262