Dig for Victory: An Analysis of Active and Passive Managers

by Jeff Mortimer, CFA and Stuart Eadon
J.P. Morgan Investment Analytics & Consulting
jeffrey.w.mortimer@jpmorgan.com

During World War II, the British government started a program with the slogan “Dig for Victory” – citizens were encouraged to grow their own food as the nation sought to reduce pressure on the public food supply brought on by the war effort and reduce overall expenditures on food. Similarly, stock market investors are feeling the pinch. As some asset managers have fallen short of investors’ expectations, individual and institutional investors are asking themselves the same question, “are these fees worth the added benefit?” In this article, we will provide insight by comparing and contrasting traditional, long-only active and passive portfolio management.

Active and passive management are two broad-based styles of managing a pool of assets. Both styles see the same investment universe but in different ways. Active managers seek to return a risk-adjusted premium that outperforms their benchmark or tracking index. Generally, active equity and fixed income managers are compensated based upon a percentage of assets. According to our analysis, active management fees for U.S. equity mandates benchmarked against the S&P 500 varied from 25 to 180 bps per annum (median fee was 51 bps). Active management fees for U.S. fixed income mandates benchmarked against the Barclays Capital U.S. Aggregate varied from 16 to 56 bps per annum (median fee was 26 bps). Security selection, sector allocation and the ability to generate alpha or risk-adjusted excess returns are reasons often cited for higher active fees.

Passive management on the other hand is a manager’s approach to mimic a set of securities, such as an index. These managers are looking to generate a return and risk profile that resembles that of an index, regardless of how the individual securities perform. Investors are still charged a management fee; however, the fees are much lower (the median fee for both equity and fixed income managers is roughly the same, 8 bps). Fees are less because buying and selling of securities occurs less frequently, suggesting that there is less active involvement in security selection and monitoring.

In this article, we will analyze two asset classes: the U.S. Fixed Income and U.S. Equity markets. We will touch on active and passive manager’s track records, alphas, the benchmarks used to index a fund, fees, and the difficulty/possibility of selecting a product.

Efficient Markets

Generally speaking, an efficient market is one in which prices of traded assets already reflect all known information about the particular instrument. Highly efficient markets or segments within an overall larger market are easier to passively track. Analyst coverage, global business presence and constant scrutiny of companies within public indices contribute to overall transparency and liquidity. It can be said that the large-cap space within the U.S. equity market is highly efficient, whereas the small- and mid-cap space is less efficient. Thus, inefficient or less covered markets and market segments present active managers with added opportunities to generate alpha. As noted above, passive managers charge less in fees than their active manager counterparts. On the flip side, active management requires more research and due diligence for exploiting market inefficiencies and purported above-average returns. For example, within the emerging markets space, markets are less efficient, less liquid, and more volatile. In these markets, active managers charge higher fees as research, and the need for consistent financial reporting and geographic presence, are requirements for doing business. Security prices within emerging markets are not always accurately priced and tend to deviate from their true discounted value of future cash flows. Therefore, active management, along with higher fees, is more prevalent within this space.

We pulled data from two broad universes: U.S. Equity and U.S. Fixed Income. Our analysis covered over 6,600 products, representing 1,577 investment management firms. Equity products were benchmarked to the S&P 500 index and fixed income products to the Barclays Capital U.S. Aggregate index. We originally started with gross returns and derived net-of-fee returns by applying an asset class-specific median fee to the above universes. The following charts and data values are based on the adjusted net-of-fee returns.

Equity Analysis

In Exhibit 1, we have taken active returns for the listed percentiles and subtracted them from the corresponding passive returns to determine which management style performed better over various time periods. As can be seen from the chart, if an investor was fortunate enough to select an active investment product within the 50% percentile or higher, the 3-year, 5-year, and 10-year returns exceeded the returns earned from passive management and the S&P 500 index. We also included down market and up market periods to the analysis, and active management returns topped passive returns as well. As would be expected, the 90th percentile posted the highest excess return over passive managers. Interestingly enough, active management paid off the most when it was needed the most – in the down market period.

Exhibit 1: U.S. Domestic Equity Universe- as of 4Q08 Active less Passive Returns (adjusted for Median Fess)
Source: J.P. Morgan Investment Analytics & Consulting, eVestment Alliance.

However, choosing a 90th percentile manager over multiple time periods is extremely difficult. We performed analysis using 5-year trailing period returns over multiple 5-year periods and discovered that only 17% of the products listed in the 90th+ percentile (e.g., 90th through 100th percentile) as of 4Q03 remained there as of 4Q08. In fact, as Exhibit 2 indicates, 73% of all products within the 90th+ percentile dropped to a lower percentile over this period with an additional 10% no longer in existence. The slippage was 59% for products within the 75th+ percentile (e.g., 75th through 89th percentile). This means that if you held a top-performing product in 2003, it is unlikely the product would still be in the same percentile in 2008. Nonetheless, our data illustrates that median fee-adjusted active returns exceeded those of passive counterparts over longer periods of time as well as protecting an investment in the event of a recessionary period like 2000-2001.

Exhibit 2: U.S. Large Cap Core Equity Universe- AS of 4Q08 Manager Movement from 2003 to 2008 (based on training 5 yr returns)
Source: J.P. Morgan Investment Analytics & Consulting, eVestment Alliance.

Fixed Income Analysis

Within the fixed income asset class, if you were to select an active product benchmarked to the Barclays Capital U.S. Aggregate Bond index, the results differed from our equity analysis. As noted in Exhibit 3, median active fixed income products for 3-year, 5-year, and 10-year and the down market period returned negative excess returns as compared to passive management. However, the median fund was slightly positive in the expansionary period of 2005-2006. Active products in the 90th+ percentile performed the best and were the only consistent products providing positive returns over the 3-year, 5-year, and 10-year periods. While passive funds may have also underperformed the Barclays Capital U.S. Aggregate index in the same time periods, empirical evidence illustrates that active fixed income products provided less value compared to passive fixed income products.

Exhibit 3: U.S. Core Fixed Income Universe- as of 4Q08 Active less Passive Returns (Adjusted for Median Fees)
Source: J.P. Morgan Investment Analytics & Consulting, eVestment Alliance.

Consistent with the equity theme of past winners having difficulty repeating future success, the same dilemma exists within the fixed income space, but to a greater degree. As can be seen in Exhibit 4, only 5% of the products within the 90th+ percentile remained as of 4Q08. A startling 90% of products dropped to lower percentiles. Of the products that dropped, only one landed in the 75th+ percentile. The majority landed in the 10th+ percentile. This observation differs from the equity analysis, in which we found that more products remained in the 90th+ percentile and the majority of downward moving products ended up in the 75th+ percentile. Our findings within the fixed income space seem reasonable since returns normally lie within a tighter band than the equity counterparts. A similar theme occurred within the 75th+ percentile; 84% of products moved down, 0% remained, and 13% were no longer in the database as of 4Q08. On a positive note, 3% moved up to the 90th+ percentile.

Exhibit 4: U.S. Core Fixed Income Universe- as of 4Q08 Manager Movement from 2003 to 2008 (based on trailing 5 yr reurns)
Source: J.P. Morgan Investment Analytics & Consulting, eVestment Alliance.

Conclusion

Nevertheless, whichever side of the line you choose, active and passive management is not an absolute term. Statistical anomalies exist in the market that may alter your manager’s alpha. A random up tick or down tick in a security may not dictate a manager’s true ability for selecting that stock. Additionally, the composition of indexes may have changed; companies became defunct and fell out of indexes while others increased their weight in the index, leaving your benchmark with different statistics that may be incomparable to your portfolio. In short, as institutional clients try to match their assets to their liabilities, thorough due diligence and attention to detail is required when selecting a portfolio management strategy and there are many criteria to consider.

In summary, active managers seek to return a risk-adjusted premium while passive managers look to mimic a set of securities such as an index. As of 4Q08 and less median fees, active equity portfolio management has provided the most excess return in down and up markets and over 3-year, 5-year and 10-year periods. On the other hand, less median fees, passive fixed income has provided the most excess return in 3-year, 5-year and 10-year periods. Thus, as the economy looks to turn the corner, it may be time to re-visit your portfolio and ask yourself: “are the fees worth the added benefit?”