Active versus Passive Management September 13 th, LAPERS Darren Fournerat, CFA, CAIA Laney Sanders, CFA

Agenda Defining “Active” and “Passive” for portfolio management Different approaches for implementation for each tactic Support for each strategy Current market dynamics Smart Beta 2

Portfolio Management Process Strategic or tactical asset allocation decisions – Allocation to a particular asset class Implementation – What is the best way to invest in that asset class? – Use Active or Passive approach? 3

Active versus Passive Active management seeks to outperform a given benchmark – Overweight or underweight securities relative to appropriate benchmark in an attempt to “beat the market” Passive management simply seeks to gain exposure to a certain market – Does not express investment expectations as to which securities will outperform within that particular market 4

Spectrum of Portfolio Management 5 Index Fund Enhanced Indexing / Semi active Long Only Benchmark constrained Long / Short Hedge Funds Passive Active

Passive Management - Indexing An index fund is a portfolio of securities that is purchased, held and managed in order to match the return and risk characteristics of an index – Two types of index funds include: Fully Replicated – An index fund that holds every single security in the index, and each position will have approximately the same weight in the fund as in the index Optimized – An index fund that holds a “representative” sample of securities that is determined by advanced mathematical programming software 6

Passive Management – Indexing Indexing is the most prevalent approach to passive investing Attempt to match the performance of a pre-specified benchmark Began in the 1970s – Quickly grown to where it is today – U.S. alone has more than $1 trillion in institutional indexed equities Despite this growth, active management still accounts for the overwhelming majority of equity assets managed 7

Active Management Seeking to outperform the market Types of Active management – Almost Passive Enhanced indexing Smart Beta – Constrained Long-only – Unconstrained Long-Short hedge fund 8

Active Management Considerations for hiring active managers – Which benchmark is appropriate? – What constraints will be placed on the manager to manage risk? Exposure limits Pre-defined sub-asset class ranges Are they allowed to short and / or use leverage? – What fees do they charge? Flat management fee? Performance based fee? 9

Support of Passive Management After fees, the return of the average actively managed dollar, will be less than the average passively managed dollar* Limited evidence that performance persistence exists – Makes consistently selecting top active managers very difficult Time and resources needed for active management 10 *Source - The Arithmetic of Active Management” by William Sharpe

Support of Active Management Market “anomalies” do exist – Size Effect – Value Effect Modern Portfolio theory / Efficient market hypothesis does not consider “behavioral biases” – Traditional theory assumes all investors act rationally 11

Market Efficiency An efficient market is one in which asset prices reflect new information rationally and quickly – Less efficient markets usually present greater opportunities for excess return, or “alpha” Market capitalization Developed versus emerging Traditional versus alternative 12

Opportunities for Outperformance 13

Current Market Dynamics Strong U.S. equity performance recently has made it difficult for active managers – S&P 500 gained nearly 75% for the three-year period ending December 31 st, 2014 – Index finished in the top quartile of Large Cap domestic active managers 14

Current Market Dynamics Why have active managers struggled? – Active managers target higher quality stocks, in general In the “risk-on” environment created by quantitative easing in the U.S., lower-quality stocks managed to outpace better-quality stocks for three years – Active managers keep some cash, or “dry powder,” to be able to quickly execute opportunities as they present themselves Cash drag is magnified when returns are high 15

Smart Beta – Growth and Popularity 16

Smart Beta Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes Take advantage of perceived systematic biases or inefficiencies in the market – i.e.: size, value, volatility Claims to offer market-beating returns with a rules based, simplistic, and low cost approach 17

Smart Beta – Growth and Popularity Key findings of Invesco’s Evolution of Smart Beta ETFs – 1 in 3 (36%) institutional decision makers indicate they are currently using Smart Beta ETFs – 64% of institutions indicate they are likely to increase their use of ETFs over the next three years – Six in ten institutional investors surveyed are now familiar with smart beta ETFs, up from 54% last year – Nearly two-thirds of institutional decision makers expect to increase their use of smart beta ETFs over the next three years 18

Smart Beta – What is holding it back? 19

How “Smart” is Smart Beta? Smart Beta portfolios are not really passive – Actively betting on certain “factors” to outperform – Decision to not hold cap-weighted index – Must decide weighting and rebalancing rules Vulnerable to being replicated, overcrowded, and are prime targets for front-running – Most of the common factors are already known by the markets – More transparent than active strategies Given the same universe, smart beta strategies are not diversifying to traditional cap-weighted indices 20

Wrapping up: Active or Passive Things to consider: – Market efficiency Less efficient markets can present an opportunity for active management to outperform – Risk tolerance Active management will expose you to some level of tracking error (active risk) – Fee tolerance The more active the strategy, the higher the fees – Staff resources Hiring and overseeing active managers takes time 21