Active, Passive or Enhanced? University of Connecticut Sandip A. Bhagat, CFA Managing Director, Citigroup Asset Management President, Travelers Investment Management Company Presented at University of Connecticut Storrs, Connecticut February 20, 2004

Discussion Points Evolution of Indexing Role of Active Management Structured Management or Enhanced Indexing as an Alternative Implementation Choices in Asset Allocation

Growth of Indexing $1.3 trillion in institutional indexed assets Vanguard S&P 500 index fund has grown 8 fold in the last 5 years $ trillion $ billion

Factors Contributing to Popularity of Indexing Shortfall of Active Management Imbalance between size of information advantage and size of active bets Academic Arguments of Market Efficiency Self-Fulfilling Prophecy

Relative Merits of Passive vs. Active Management Indexing Active Reason Relative Performance - Efficient Asset Class   Empirical - Inefficient Asset Class   Evidence Relative Costs   Low Info. Needs/ Turnover Implementing Asset Allocation   Style Reliability Tax Efficiency   Low Turnover

Potential Risks of Indexing to the S&P 500 Reversal of Size and Style Effects Lower Financial Asset Returns Shift Focus to Active Management Reversal of Self-Fulfilling Prophecy

Role of Active Management Good active managers deliver consistent value-added relative to a benchmark. Good active managers will never fall out of favor or go out of style. Active management should be used in inefficient asset classes.

Evaluating Active Management Information ratios provide the litmus test of active management. IR =   = = Active = Portfolio - Benchmark A high information ratio differentiates skill from luck in active management. > + 0.5 Good < - 0.5 Bad  Active Return Active Risk  

Evaluating Active Management t-statistic = IR = , Standard Error of IR = 1/ IR > 0.5 implies a top quartile manager Estimate Standard Error T

t - statistic of 1.6 implies a 90% Evaluating Active Management t - statistic of 1.6 implies a 90% confidence level 0.5 If it can take more than 10 years to confidently identify a skilled active manager, how long would it take to identify a lucky or incompetent one? > 1.6 T > 10 years T 1 /

Skill and Luck More Luck Insufferable Blessed Less Skill More Skill Doomed Forlorn Less Luck

Structured Management or Enhanced Indexing As An Alternative Disciplined investment style Provides reliable asset class exposure Adds value in a risk-controlled process Combines desired attributes of reliability (purely passive) and value-added (purely active) into one style Enhances asset allocation decision through risk control and value-added

Evolution of Asset Management Styles Expected Return Payoffs Relative to Benchmark Share of Enhanced vs. All Indexing 4 to 8% 30% 1 to 3% -0.1 to -0.3% -1 to -3% < 5% -4 to -8% Asset Class Less More Reliable Exposure Reliable Reliable Value Added Less More Reliable, Reliable Reliable but zero

Expectations From Enhanced Indexing Enhanced indexing represents a middle ground relative to passive and active management in terms of active risk, active returns and advisory fees. Large Mid Small Active Risk, bps 100-200 200-300 300-400 Active Return, bps 50-100 150-180 150-300 Advisory Fees, bps 10-25 25-50 50-70

Enhanced Indexing Approaches Achieve measured, focused and selective departures from index composition Conventional Strategies - Statistical Arbitrage or Research Enhanced Downside Suitability for Strategy Breadth Risk Enhanced Indexing Stock Selection High Low  (sector, size, style neutral) Industry Rotation Moderate Moderate  Sector Rotation Lower High  Style Rotation Low High  Size Rotation Low High 

Enhanced Indexing Approaches Portable Alpha Strategies (Tracking Error 1 to 3%): LIBOR Plus + Futures S&P 500 = S&P 500 Plus Market Neutral + Futures S&P 500 = S&P 500 Plus Long-short Convertible + Futures S&P 500 = S&P 500 Plus Arbitrage Mid Cap Alpha - Futures Mid cap + Futures S&P 500 = S&P 500 Plus (Any Inefficient Asset Class) Derivatives arbitrage (eg. stock-index futures, rolling cheap calendar spreads) is now efficiently priced

Importance of “Breadth” in Active Management Information Ratio = Skill . Breadth* IR = IC . IC = Information Coefficient BR = Number of Independent Bets per Year BR IC BR IR = IC . Stockpicker 0.05 200 0.71, Excellent Market timer 0.12 2 0.18, Mediocre BR *Source: Grinold & Kahn

Probability of Success Across Investment Strategies Skill Probability Investment Strategy Breadth Required of Success Diversified Active High Lower Higher Concentrated Active Low/Mod Higher Mod Style Allocation Mod Mod Mod TAA, Mkt. Timing Low Higher Lower

Passive vs. Active: Role of Market Efficiency Active management can be futile in efficiently priced markets (by definition). Markets are generally efficient in the longer term but may provide short-term opportunities to exploit mispricing. Emphasize active management in inefficient asset classes.

Market Efficiency and Implementation Choice Market Recommended Mix Asset Class Efficiency Passive Enhanced Active (%) (%) (%) Large U. S. Stocks High 40 30 30 Small U. S. Stocks Low - 30 70 Core Int’l. Stocks Mod 30 30 40 Emerging Mkts. Stocks Low - 20 80 U. S. Bonds High 30 40 30 Foreign Bonds Mod 20 30 50 Emerging Mkts. Debt Low - 20 80

Summary Various forms of indexing are likely to dominate in efficient asset classes. Enhanced indexing combines reliability and value-added to enhance asset allocation decisions and may represent a cheaper outperformance call option Active management can add significant value in inefficient asset classes by exploiting superior information. Good active management, if you can find it, will always be in demand!