1. The Active vs. Passive Investment Debate Discussion on: The Rewards and Risks of Active vs. Passive Investment Management
On the One hand…..
….. And on the Other Hand
Harry Marmer, CFA, MBA – Executive Vice President, Hillsdale Investment Management

2. Agenda Are Markets Efficient? Can Managers Add Value?
Where is Active Management Going?

3. Definitions Passive (Index) Management Two Meanings
Security Selection:
Match performance of an asset class index such as the S&P/TSX Composite Index
Asset Mix:
Match performance of a policy mix (such as 50% stocks/50% bonds)

4. Definitions Active Management Two Strategies Market Timing:
Timing asset class exposure to earn a return that exceeds the return available by maintaining a constant asset mix (for e.g. 50% stocks/50% bonds)
Security Selection:
Selecting securities to earn a return that exceeds the return available from investing in an index such as the S&P/TSX Composite Index

5. Market Timing Track Record – Low Odds Strategy North American Value Added Experience
Average Annual Value Added
Asset Mix Timing Security Selection
Source: The Portable Pension Fiduciary: A Handbook for Better Pension Fund Management
(Toronto: Benefits Canada, 1997 page 62) , by John Ilkiw

6. Why Market Timing is Unprofitable?
“Historical Analysis Indicates You Must Be Right At Least 2/3 of the Time*
Bull markets last longer than Bear markets
Stocks go up more over time than go down
Most upward performance occurs in unpredictable spurts
*Source: Bill Sharpe, “Likely Gains from Market Timing” Financial Analyst Journal (March/April 1975, Pg 60-69)

7. Active vs. Passive Investment Management
Security Selection
Issues to Consider:
Philosophical
Practical
Is the Market Efficient?
Can Active Managers
“Beat the Market?”

8. A. Philosophical: Is the Market Efficient?
Eugene Fama (1965)
Efficient Market =
Securities Reflect All Available Information
What Does This Mean?
Investors Earn Returns Commensurate with Risk, ie., No Free Lunch
Various Forms of Theory:
Weak
Semi-Strong
Strong

9. A. Philosophical: Is the Market Efficient?
Weak Form
A security’s price reflects all the information contained in the
historic price record. Past prices cannot provide information
of any value in helping to determine future prices.
Semi Strong Form
At any given time, all relevant public information is fully
reflected in the security’s price.
Strong Form
All public and private information is fully reflected in the
security’s price

10. A. Philosophical: Is the Market Efficient?
So…What Do Academics Think?
1960 – 1970’s
Markets Are Efficient Except to Some Degree in the Strong Form

11. Proliferation of Databases and Software

12. A. Philosophical: Is the Market Efficient
Computers & Databases led us to:
Small Firm Effect
Weekend and Monday Effect
January Effect
Low P/E Effect
Low P/Book Effect

13. A. Philosophical: Is the Market Efficient?
1990’s : 3 Views
1. Markets ARE Efficient
Data Mining
Fees
Risk
2. Markets are NOT Efficient
Technical Trading Patterns
Chaos
A.I., Neural Net
TAA – Forecast Returns (Fama)
3. Bounded Market Efficiency
Professional vs. Noise Traders (ie, Banks, Individuals, the Herd)
Fads, Bubbles, etc

14. The Market is Efficient?.
Postwar Movements in S&P Index and Their Causes*
Date
Percentage Change
New York Times Explanation 1
19-Oct-87
-20.47%
Worry over dollar decline and trade deficit; Fear of US not supporting dollar 2
21-Oct-87
9.10%
Interest rates continue to fall; deficit talks in Washington; bargain hunting 3
29-Sep-08
-8.80%
Congress Votes against Wall Street bailout package 4
26-Oct-87
-8.28%
Fear of budget deficits; margin calls; reaction to falling stocks 5
3-Sep-46
-6.73%
"…. No basic reason for the assault on prices" 6
28-May-62
-6.68%
Kenndy forces rollback of steel price hike 7
26-Sep-55
-6.62%
Eisenhower suffers heart attack 8
26-Jun-50
-5.38%
Outbreak of Korean War 9
20-Oct-87
5.33%
Investors looking for "quality stocks" 10
9-Sep-46
-5.24%
Labor unrest in maritime and trucking 11
16-Oct-87
-5.16%
Fear of trade deficit; fear of higher interest rates; tension with Iran 12
27-May-70
5.02%
Rumours of change in economic policy. "….the stock surge happened for no fundamental reason" 13
11-Sep-86
-4.81%
Foreign governments refuse to lower interest rates; crackdown on triple watching announced 14
17-Aug-82
4.76%
Interest rate declines 15
29-May-62
4.65%
Optimistic brokerage letters; institutional and corporate buying; suggestions of tax cut 49
30-Nov-82
3.23%
"..analysts were at a loss to explain why the Dow jumped so dramatically in the last two hours.." 50
24-Oct-62
3.22%
Khrushchev promises no rash decisions on Cuban Missile Crisis; calls for US-Soviet summit . . . . .
Less than 25% of Major Moves can be Attributed to a Specific World Political or Economic Event**
*Source: Hillsdale Investment Management Inc.
*Source: NBER Working Paper No. 2538, “What Moves Stock Prices?”, by David Cutler, James Poterba, and Lawrence Summers, March In “Events
That Shook The Market”, Roy C. Fair found that “many large stock price changes have no events associated with them” , Page 713, Journal of Business 2002
**Source: Page 217, Chapter 13, World Events That Impact Financial Markets, “Stocks for the Long Run”, Jeremy J. Siegel,

15. B. Can Active Managers “Beat the Market”
Active Passive

16. The Secret Formula of Active Investment Management
The Fundamental Law of Active Management
Information Ratio = Manager’s Skill × √ Breath
Number of Independent Forecasts of E ( R )
Relationship Between Forecasts and Actual Outcomes
Information Ratio = (Excess Return)/(Tracking Error) Tracking Error = Standard Deviation of Excess Return
Source: Active Portfolio Management, by R. Grinold & R. Kahn, McGraw Hill, New York, NY, 2000

17. In Other Words, Smart Managers Count Cards

18. Let’s Review If There are Smart Managers and if They Can Count Cards
Cdn Fixed Income
Cdn Equity
U.S. Large Cap
U.S. Small Cap
Global Equity

19. How Have Active Canadian Bond Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd Quartile Managers vs. Scotia Capital Universe
Data Source: Mercer Investment Consulting Pooled Fund Survey

20. Tough to Sell Active Canadian Fixed Income
Annual Spread (%) Between Canadian Fixed Income Managers:
1st Quartile vs. Median and 3rd Quartile vs. Median
1st Quartile - Median:
Mean ( ) = 0.72
1st Quartile - Median:
Mean ( ) = 0.34
3rd Quartile - Median:
Mean ( ) = -0.36
3rd Quartile - Median:
Mean ( ) = -0.62
Data Source: Mercer Investment Consulting Pooled Fund Survey

21. Why is the Canadian Bond Market so Tough to Beat?
What Unique Information do Managers Have on Interest Rates?
How Many Times Can They Apply These Forecasts?
How Do You Beat The Bond Market?
“Call” on Interest Rates
Spreads

22. How Have Canadian Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd Quartile Managers vs. S&P/TSX Composite
1st Quartile - TSX
Mean ( ) = 4.9
1st Quartile - TSX
Mean ( ) = 11.9
1st Quartile - TSX
Mean ( ) = 2.7
3rd Quartile - TSX:
Mean ( ) = -1.5
3rd Quartile - TSX:
Mean ( ) = -2.7
3rd Quartile - TSX:
Mean ( ) = -1.9
Statistics
1st Quartile –
S&P/TSX Composite
Median –
3rd Quartile –
Mean
5.9
2.1
-1.9
Median
4.0
0.9
-1.5
Stdev
5.7
4.8
5.4
High
20.4
12.7
5.6
Low
-0.8
-6.1
-19.2
Source: eVestment Alliance

23. How Have Canadian Small Cap Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd Quartile Managers vs. S&P/TSX Small Cap Index
Statistics
1st Quartile –
S&P/TSX Small Cap
Median –
3rd Quartile –
Mean
12.3
6.1
0.6
Median
14.1
8.0
2.1
Stdev
7.3
6.3
High
22.2
15.2
8.5
Low
-3.8
-9.0
-13.4
Source: eVestment Alliance

24. How Have U.S. Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd Quartile Managers vs. S&P 500 Index
1st Quartile – S&P 500
Mean ( ) = 11.3
1st Quartile – S&P 500
Mean ( ) = 4.4
1st Quartile – S&P 500
Mean ( ) = 5.1
3rd Quartile – S&P 500:
Mean ( ) = -2.5
3rd Quartile – S&P 500:
Mean ( ) = -2.8
3rd Quartile – S&P 500:
Mean ( ) = -6.8
Statistics
1st Quartile –
S&P 500
Median –
3rd Quartile –
Mean
6.2
1.2
-3.6
Median
5.3
1.4
-2.6
Stdev
4.4
2.9
3.6
High
19.1
9.7
0.7
Low
-4.2
-12.5
Source: eVestment Alliance

25. How Have U.S. Small Cap Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd Quartile Managers vs. Russell 2000 Index
1st Quartile – R2000
Mean ( ) = 22.2
1st Quartile – R2000
Mean ( ) = 11.1
1st Quartile – R2000
Mean ( ) = 6.6
3rd Quartile – R2000:
Mean ( ) = -6.6
3rd Quartile – R2000:
Mean ( ) = -2.0
3rd Quartile – R2000:
Mean ( ) = -4.3
Statistics
1st Quartile –
Russell 2000
Median –
3rd Quartile –
Mean
11.4
3.4
-3.5
Median
11.1
3.3
-3.6
Stdev
7.3
4.4
4.5
High
25.6
16.1
3.9
Low
0.8
-2.9
-15.3
Source: eVestment Alliance

26. How Have Global Equity Managers Faired?
Annual Excess Returns (%) of 1st Quartile, Median and 3rd Quartile Managers vs. MSCI World Index
1st Quartile – S&P 500
Mean ( ) = 7.6
1st Quartile – S&P 500
Mean ( ) = 10.6
1st Quartile – S&P 500
Mean ( ) = 5.1
3rd Quartile – S&P 500:
Mean ( ) = -1.9
3rd Quartile – S&P 500:
Mean ( ) = -0.6
3rd Quartile – S&P 500:
Mean ( ) = -2.5
Statistics
1st Quartile –
MSCI World
Median –
3rd Quartile –
Mean
7.4
2.4
-1.4
Median
6.3
2.2
-1.9
Stdev
5.4
3.5
3.2
High
21.0
7.7
4.8
Low
-0.8
-5.3
-8.1
Source: eVestment Alliance

27. So…..Can Active Managers “Beat the Market?”
Asset Class
Breadth
Skill
Odds of Success
Cdn. Fixed Income
Low
Cdn. Equity
Avg.
Cdn. Small Cap
High
U.S. Equity
U.S. Small Cap
Global Equity

28. Long Term Observations…..
Active vs. Passive Management
Average Manager Return = Market Return
i.e., Market Return = Passive Portfolios + Active Portfolios
The Market Rewards Different Factors over Time
Successful Active Managers Need Both Skill and Breadth
Active Management Pay Off For Managers in The Top Third of the Universe
“Properly measured, the average actively managed dollar must under-perform the average passively managed dollar net of costs. Active management is indeed a zero-sum game”
– Bill Sharpe, Noble Prize Winner in Economics
Source: The Arithmetic of Active Management: Does Fund Size Matter? Reprinted with permission from The Financial Analysts' Journal Vol. 47, No. 1, by William Sharpe, January/February pp. 7-9 Copyright, 1991, Association for Investment Management and Research, Charlottesville, VA

29. So Why Can Active Management Sometimes Be Frustrating From a Client Perspective?
Over Emphasis on Short Term Past Performance
Under Emphasis of Manager “Style” and Process
Change vs Shift in Investment Process
Organizational Uncertainty Challenges
Success Can Lead to Mediocrity

30. Success Can Lead to Mediocrity
Why?
“Bets” Diminish Over Time Due To:
Increase in AUM
Increase in Transaction Costs
Increase in “Qualified” (CFA Charterholder) Employees
Business Decision
No Skill
Protective Mode
Source: Mutual Fund Performance: Does Fund Size Matter? Financial Analyst Journal, by Daniel C. Indro, Christine X. Jiang, Michael Y. Hu and Wyne Y. Lee, May 1999, The Evolution of Investment Processes, by Paul Greenwood, Russell Research Commentary, June 1999.

31. Alpha Shrinkage As Assets Multiply“
The real business of money management is not managing money, it is getting money to manage.
Mark Hurley, Goldman, Sachs and Co.,
Evolution of the Investment Management Industry ”
Value Added
Beat the Market
Assets Under Management
Lose to the Market
Source: Asset Growth and Its Impact on Expected Alpha, by R.Kahn, in Global Perspectives on Investment Management, CFA Institute, 2006, pages 197 – 212

32. Do We Really Understand Execution?
Commission
5¢ (17bp)
Impact
10 ¢ (34 bp)
Delay
23 ¢ (77 bp)
Missed Trades
9 ¢ (29 bp)
Source: Plexus Group
Source: Analyzing Transaction Cost: Part 1: Wayne Wagner and Steven Glass, The Journal of Investment Consulting, June 1999.

33. The Elephant In The Room“
Imagine a business in which other people hand you their money to look after and pay you handsomely for doing so. Even better, your fees go up every year, even if you are hopeless at the job. It sounds perfect. ”
The Economist
March 1, 2008, Special Report on Asset Management

34. Meeting the Success Challenge In The Investment Management Industry
Investors Will Pay More Attention to Firm’s Business model
Questions of Capacity will Come up More Frequently
Capacity Serious Investors Will Employ Performance Based Fees
This Will Lead More Managers to Focus on Maximizing Alpha as Opposed to Maximizing Assets

35. Where Is Active Management Going?
Canadian Equity Plus
130/30
Small Cap
Market Neutral/Portable Alpha
Why?
The Fundamental Law of Active Investment Management Plus The Power Of Diversification

36. The Power of Diversification
The Greater the Negative Correlation Between 2 Investments, the Greater the Contribution to Reducing Risk.
This Relationship is Non- linear.
Contribution to Excess Return/Risk
Short Selling
Portable Alpha
Market Neutral
T-Bills
Long-Bonds
World Equities
Cdn. Equities
Correlation

37. The Spectrum of Active Management Strategies
< 18%
Small
Cap
Cdn.
Equity
Plus
130/30
Long
Short
Equities
Expected Return
< 10%
Portable
Alpha &
Market
Neutral
60/40
Long
Bonds
< 5%
T-Bills
< 7%
< 11%
< 16%
Risk

38. Market Neutral Is Also An Excellent Diversifier
Return Correlations From Jan 1994 – June 2008
S&P
TSX
500
MSCI
EAFE
Scotia
Macleod
Universe
CSFB MN
Equity
Index
Cdn. 91
Day
T-Bill
S&P/TSX*
1.00
S&P 500*
0.63
MSCI EAFE*
0.59
0.73
Universe*
0.18
0.12
0.01
CSFB
MN Equity
0.06
-0.06
0.03
Cdn. 91 Day
T-Bill*
-0.07
0.09
0.00
.02
0.14
* Indices are Total Returns in $Cdn. CSFB Returns are $US

39. The Active vs. Passive Management Debate
Most “Traditional” Strategies Still Work
Index or LDI Canadian Bonds and “Port Alpha on Top” or Accept Less
“Extension” Strategies Increase the Odds of Success
Small Cap Can be Big
Always Consider the Fundamental Law of Active Management