Institutional investors are prudent to rely on active management strategies for equity investing in non-US markets. The authors provide numerical estimates for active management’s performance advantage relative to that of passive management. They attribute their results to an underlying market efficiency and investor sophistication.
The authors examine the empirical evidence for the common academic guidance that even sophisticated investors should avoid active equity management because of the outperformance of passive strategies after costs. They confirm this advice’s validity for the US equity market, the world’s most efficient market, but identify exceptions elsewhere.
For non-US markets covering developed market economies (EAFE—that is, Europe, Australasia, and the Far East) and, in particular, emerging market economies, active management by institutional investors does pay, suggesting a real ex ante effect for the efficiency of an equity market. The authors further determine that this active benefit is concentrated during recessionary periods; is the result of learning by plan managers; is related to institutional constraints, especially for developing economies; and is not based on increased risk taking.
How Is This Research Useful to Practitioners?
For institutional investors already using targeted active management—for example, those responsible for large pension plans in the corporate sector—the authors’ results may seem obvious. Confirmation of the actions of peers, however, can have value.
For the potential minority who decline to pursue active approaches despite the lack of investment charter prohibitions, the authors offer quantitative specificity, as opposed to anecdotes, on opportunity costs. They estimate that the approximate annual spreads favoring active management, net of costs, are 180 bps for emerging markets and 50 bps for EAFE. In US equities, active management underperforms a passive strategy by 28 bps a year. These results remain statistically significant when controlling for risk on a variety of dimensions. The authors also estimate that active management must overcome an average fee hurdle of about 35 bps annually. These metrics are all informative benchmarks to assess the choice of active versus passive management.
To advisers focusing on individuals, the authors reiterate the suitability of passive investing even outside the United States—at least in the developed economies. Regarding EAFE equities, they calculate an average before-cost differential in favor of active management of only 78 bps annually and believe that spread may be inadequate to offset associated fees. They also offer the prudent caution that the passive option is only as good as the underlying instruments for implementing it. In emerging markets, such instruments are tangibly sparse compared with those available in the US equity market.
How Did the Authors Conduct This Research?
The authors are meticulous in examining various dimensions of their research questions, in acknowledging potential data biases, and in confining conclusions to the limits of their empirical evidence. They rely on annual proprietary data for the years 1993–2008 on defined benefit (DB) pension plans provided voluntarily by plan administrators to CEM Benchmarking of Toronto for comparative internal analysis of plan costs and return performance.
Approximately 40% of total US DB plan assets and 65% of Canadian DB plan assets are covered by their sample, with particularly strong representation of large plans (average size of $8 billion). The data are well suited for their research because they directly track passive and active equity portfolio components, differentiate across the three major geographic categories (the United States, EAFE, and emerging markets), and enable the calculation of net returns based on actual costs.
Multiple regression analyses determine baseline performance comparisons for active versus passive management, which are tested for risk-related effects using a “world” capital asset pricing model and multifactor models with global market return, value, size, and momentum serving as risk factors. Timing effects are examined by noting the impact of economic cycles (active management being beneficial in downturns) and progressive learning by managers (increasing non-US active exposure and US passive exposure over the sample period). Finally, the effects of plan size and sponsorship are investigated to confirm that public sector and smaller plans are less likely to rely on active management.
The authors are persuasive in their careful argument that it would be inappropriate for all institutional investors to rely exclusively on passive management across all markets and conditions. Although it seems reasonable to expect that global investing will evolve similarly to investing in the United States, with declining excess returns from market inefficiencies over time, for the foreseeable future, neglecting opportunities in skillful active management will likely leave money on the table to the detriment of fiduciary responsibilities. And with emerging markets’ constituting an ever-growing share of global GDP, a self-imposed return handicap does not address the potential diversification benefits for investors based in developed economies.