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

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

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)

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

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

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)

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

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

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

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

Proliferation of Databases and Software

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

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

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 1988. 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,

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

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

In Other Words, Smart Managers Count Cards

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

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

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 (1986-1997) = 0.72 1st Quartile - Median: Mean (1998-2007) = 0.34 3rd Quartile - Median: Mean (1998-2007) = -0.36 3rd Quartile - Median: Mean (1986-1997) = -0.62 Data Source: Mercer Investment Consulting Pooled Fund Survey

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

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 (1990-1998) = 4.9 1st Quartile - TSX Mean (1999-2002) = 11.9 1st Quartile - TSX Mean (2003-2007) = 2.7 3rd Quartile - TSX: Mean (1990-1998) = -1.5 3rd Quartile - TSX: Mean (2003-2007) = -2.7 3rd Quartile - TSX: Mean (1999-2002) = -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

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

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 (1998-2001) = 11.3 1st Quartile – S&P 500 Mean (1990-1997) = 4.4 1st Quartile – S&P 500 Mean (2002-2007) = 5.1 3rd Quartile – S&P 500: Mean (2002-2007) = -2.5 3rd Quartile – S&P 500: Mean (1990-1997) = -2.8 3rd Quartile – S&P 500: Mean (1998-2001) = -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

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 (1999-2001) = 22.2 1st Quartile – R2000 Mean (1990-1998) = 11.1 1st Quartile – R2000 Mean (2002-2007) = 6.6 3rd Quartile – R2000: Mean (1999-2001) = -6.6 3rd Quartile – R2000: Mean (1990-1998) = -2.0 3rd Quartile – R2000: Mean (2002-2007) = -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

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 (1990-1997) = 7.6 1st Quartile – S&P 500 Mean (1998-2001) = 10.6 1st Quartile – S&P 500 Mean (2002 - 2007) = 5.1 3rd Quartile – S&P 500: Mean (2002 - 2007) = -1.9 3rd Quartile – S&P 500: Mean (1990-1997) = -0.6 3rd Quartile – S&P 500: Mean (1998-2001) = -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

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

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 1991. pp. 7-9 Copyright, 1991, Association for Investment Management and Research, Charlottesville, VA

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

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.

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

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.

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

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

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

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

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

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

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