#1Active and Passive Investing Theory, evidence, and advice Pete Hecht, Ph.D. Managing Director, Portfolio Solutions Group May 2019 AQR 237/635 Private and Confidential; For Institutional Investor Use Only#2Disclosures The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC ("AQR") to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. This document is subject to further review and re vision. Please refer to the Appendix for more information on risks and fees. For one-on-one presentation use only. Past performance is not a guarantee of future performance. This presentation is not research and should not be treated as research. This presentation does not represent valuation judgm ents with respect to any financial instrument, issu er, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the speaker nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the speaker will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the speaker guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. The information in this presentation may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely. Neither AQR nor the speaker assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of AQR, the speaker or any other person as to the accuracy and completeness or fairness of the information contained in this presentation, and no responsibility or liability is accepted for any such information. By accepting this presentation in its entirety, the recipient acknowledges its understanding and acceptance of the foregoing statement. AOR 238/635 2#3A little theory...clearing up some confusion (AQR 239/635 3#4Believing in Efficient Markets and Active Management Can Coexist Neither rational nor behavioral economists would hold the market Eugene F. Fama Father of efficient markets; 2013 Nobel laureate in economics SITY OF AGO (AOR THE UN СР Y OF THE UNIVERSIT CHICA The real debate is about why they don't hold the market Richard H. Thaler Father of behavioral finance; 2017 Nobel laureate in economics Source: AQR, Famouseconomists.net, faculty.chicagobooth.edu, russellsage.org/ro. The use of the logos and pictures is for informational purposes only and is not authorized by, sponsored by or associated with the trademark owners. 4#5The Arithmetic of Active Management A negative sum game? Not so fast... "It must be the case that: - before costs: average active return = passive return - after costs: average active return < passive return ...these assertions... depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required." Sharpe's arithmetic is often cited as proof that active management is doomed William Sharpe, 1991 Not so fast... Sharpe assumes passive investors never trade Assumption does not hold in the real world: IPOs, index inclusions/deletions, etc. This breaks the equality: when passive investors trade, they may get worse prices So active management can be worth positive fees in aggregate Empirical questions: Do they actually add value? If so, how much? Also, it should be called the arithmetic of active investing Active investors do not only include delegated managers, but also retail and institutional internal investing: latter are large, not publicly measured ● (AQR) P Sharpening the Arithmetic of Active Management and NY пах Lasse Heje Pedersen Lalat AQR Capital Management Greenwich Connect, un progen Rino Somal Ichallenge William F. Sharpe's famous equality that "before costs. the return on the average actively managed dollar will equal the return on the average passively managed dollar. This equality is based on the implicit assumption that the market portfolio never changes, which does not hold in the real world because new shares are issued, others are repurchased. and indexes are reconstituted-so even passive investors must regularly trade. Therefore, active managers can be worth positive fees in aggregate, allowing them to play an important economic role helping allocate resources eff dently Passive investing also plays a useful economic role: creating low-cost access to markets. Die Theerthoris a principa at AQR Capital Management, a dob investment management firm, which may or may not apply similar invest tachometheads of analysis a described in The views expressed necessarily those of A CEC05 * See for example Fama, Eugene F., and Kenneth R. French (2010), "Luck versus skill in the cross-section of mutual fund returns," The Journal of Finance. 41/635 For illustrative purposes only. Image courtesy of http://www.nobelprize.org/nobel prizes economic-sciences/laureates/1990/sharpe-bio.html (Ra) Perspectives harpe's (1991) famous "arithmetic of active management states it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar, and (2) after costs, the return on the average actively managed dollar will be less These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required. (p. 7: italics in the originall Sharpe's arithmetic has been invoked by Warren Buffett is often stated as incontrovertible fact by speakers at conferences followed by a triumphant "QED!"), and is cited as proof that active management is "doomed" in aggregate (French 2008). If active management is doomed in aggregate, then so is our market-based financial system because we need someone to make prices informative. However, we may avoid doom on the basis of my arithmetic. Sharpe's powerful insight is that one active investor's gain is another active investor's loss, which aggregates to zero for all active investors. This useful insight is correct when considering a fond set of securities over a single time period, but in the real world, the set of securities in the market changes over time. fdcom Anbu C Ashute Devid Tttarita rosur Mms Clickr MG Com Sartond Se Devid Jon Debet C Martin Tidy Moireet, Li Pe Bag Scotchon Wien F. Sharpe, S Articipo a CFAS Det the sty at Drag ere Come ant at the New Desi Larg:amaCurt 21 LO 5#6Empirical Evidence of Active Managers' Performance (AQR 242/635 6#7Have Active Managers Outperformed in the Long Run? Apparent positive empirical performance of active managers as a group For mutual fund and institutional equities, we see positive excess returns over the past 20 years Institutional equity managers have had a better long-run track record We focus here on net-of-fee alpha, although some academics emphasize that gross alpha or the dollar value added are more relevant for measuring manager skill (e.g. see Berk-van Binsbergen (2015)) ● Net/Gross Universe Simple Excess Returns vs. Benchmark Benchmark/Market Avg (% p.a) "Active Risk" (% p.a.) "Information Ratio" Active Returns: Beta-Adj. CAPM Alpha (Rolling 24mo) Benchmark/Market Avg (% p.a) Active Risk (% p.a.) Information Ratio (AOR Mutual Fund Equities Net Morningstar: U.S. & Intl Equity Benchmark 0.06 1.70 0.04 MSCI World 0.31 1.65 0.19 Institutional Equities Gross-50bp e Vestment: U.S. & Intl Equity Benchmark 1.18 1.61 0.73 MSCI World 1.16 1.42 0.81 The institutional equities series is from January 1997 to June 2017, and the mutual fund series is from January 1997 to December 2016. Source: AQR, Morningstar, eVestment. "Equity Benchmark" is manager specific speeenchmark. The beta-adjustments use rolling 24-mo betas. For institutional funds, we use full-sample betas for 1997-98. For illustrative purposes only. Please read important disclosures in the Appendix. 7#8Have Active Managers Outperformed in the Long Run? (cont.) Apparent positive empirical performance of active managers as a group However, evidence is less compelling during the past decade than during the preceding one Cumulative Excess Return Over Benchmark, 1997 - 2017 Mutual Fund Equities and Inst. Equities $135 $130 $125 $120 $115 $110 $105 $100 $95 (AOR 1997 1999 2001 2003 2005 -MF-Eq 2007 2009 2011 -Inst-Eq 2013 2015 2017 Source: AQR, Morningstar, eVestment. Details of all the series are shown on provinsi Mutual Fund-Equity data ends Dec 2016. MF-Eq and Inst-Eq are defined by general categories from Morningstar and eVestment. Past performance is not a guarantee of future performance. Please read important disclosures in the Appendix. 8#9Have Active Managers Outperformed in the Long Run? (cont.) Apparent positive empirical performance of active managers as a group Despite positive alphas on the previous page, our inferences are colored by the oft-quoted experience of U.S. mutual fund managers with negative net alphas since 1960s Indeed, it is important to recall that measured alphas may be exaggerated by reporting biases, e.g., survivorship and backfill biases To what extent do the positive alphas for the average active manager reflect reporting biases and to what extent true outperformance by delegated active managers? The jury is still out. (AOR We won't be needing that sample... Source: AQR, linkedin.com. The use of the logos and pictures is for informationa on 5/35ly and is not authorized by, sponsored by or associated with the trademark owners. Please read important disclosures in the Appendix. 9#10Which End-Investors Are More Likely to Earn High Active Returns? Large institutional investors have outperformed historically As shown previously, institutional equity investments have earned higher active returns than mutual funds Again, the caveat is that reporting biases may be more pronounced for them ● Among institutional e quity managers, larger institutions have historically performed better Dyck and Pomorski (2011) show this for North American pension funds, endowments, and other investor groups Large investors' edge partly reflects their ability to achieve lower fees from external managers more alpha ● (AOR less alpha Source: AQR, twenty bridge.com. For illustrative purposes only. Large institutions by AUM; CEM database has 841 separate plans that are skewed towards the largest plans that have the resources and incentives to pay for the benchmarking service, for example including in 2007 57 of the top 100 plans in the U.S. See previous slide for further details. The use of the logos and pictures is for informational purposes only and is not authorized by, s/635r associated with the trademark owners. Please read important disclosures in the Appendix. S 10#11Which Active Managers Are More Likely to Outperform? Simple systematic rules offer limited help in picking winning managers Favoring past winners can make sense, even if performance-chasing flows may be excessive. There is some evidence of active managers' alpha persistence Various academic surveys* discuss this and other helpful characteristics. However, there are few uncontested systematic results in the literature Some evidence may reflect reporting biases (survivorship, backfill,...), e.g., the sometimes-claimed edge of smaller and younger funds While there are few uncontested results, it is worth noting that this line of academic research focuses on relatively simple, publicly available information ● ● Access to private information and proprietary analysis may materially raise the odds of choosing outperforming managers Most credible manager selection services put very little weight on the simple measures used in the literature. The main weight in due diligence is often on highly subjective components (AOR I'VE GOT IT DOWN το FOUR ROBERT 7 Funds -Eeny -meeny miney moe FOOOOOO EDA on *Jones-Wermers (2011), Jones-Mo (2017), Bollen-Joenvaara-Kauppila (2017) us Source: AQR, Robert Thompson Cartoons. For illustrative purposes only. The 247/635s and pictures is for informational purposes only and is not authorized by, sponsored by or associated with trademark Please important disclosures in Appendix. 11#12What Are Good/Bad Contexts for Active Managers? Look for dusty corners and patsies Dusty corners of financial markets are often thought to be less efficiently priced Such dusty corners are characterized by few active managers and few fundamental analysts Candidates include Small/micro-caps, Emerging/frontier markets ● Counterargument: These dusty corners have higher fees, and they too have active losers. Fam a has argued that the Sharpe's arithmetic applies in every corner* ● Since every investor cannot pick a top-quartile manager, active managers' aggregate net performance could actually be worse in such high-fee contexts Beyond dusty corners, it may be worth seeking markets with a large pool of likely negative-alpha players Poker analogy: You'd rather play with patsies than with sharks Thus look for markets with many unsophisticated investors and/or non-economically motivated participants ● (AOR * Fama-French Forum "Why Active Investing is a Negative Sum Game" (2009) Source: AQR, Social Poker NYC. The use of the logos and pictures is for informat48/635ses only and is not authorized by, sponsored by or associated with the trademark owners. Please read important disclosures in the Appendix. 12#13What Are Good/Bad Times for Active Managers? Common structural tilts can lead to head- or tailwinds in measured alpha Recent years have seen historically low and often negative active returns for delegated managers • Is this just a random bad spell, a sign of ever-tougher competition, or can some environmental features explain this underperformance? Skill-based argument: Low dispersion across stocks and low market volatility may have given an abnormally poor opportunity set There may be periods when common structural tilts by active managers give serious headwinds or tailwinds U.S. large-cap equity managers faced a bad draw in 2010s as their three most common out-of-benchmark tilts - favoring (i) small caps, (ii) foreign stocks, (iii) cash - all hurt them ● As shown below, these three structural tilts have explained almost half of these active managers' excess return variation over time. Little to do with skill. It was abnormally hard to beat U.S. large-cap indexbenchmarks during a bull market led by U.S. large-cap stocks. The implication is that recentpoor performance of U.S.large-cap equity managers is at least partly cyclical/reversible rather than secular Regression Evidence of U.S. Large-Cap Mutual Funds' Typical Active Tilts Beta t-Stat* AQR Small Cap vs. Large Cap 0.11 4.36 Internation al vs. U.S. 0.07 2.99 Cash vs. Large Cap 0.03 2.32 Alpha (% p.a.) -2.4% -0.94 R² 0.44 Rolling 6 Month Return 6% 4% 2% 0% -2% -4% 1997 Минзорати 1999 2001 2003 2005 MF Large-Cap - Actual 2007 2009 2011 2013 MF Large-Cap-Fitted *t-Stats reflect Newey-West adjustments Source: AQR, eVestment, Morningstar. Bold estimates have t-stats greater than 1.96 or less than -1.96, denoting significance at the 95th percentile confidence interval. Common out- of-benchmark tilts explain active manager performance. Data from June 1997 to 4935016. The regressions above use factors identified by Constable and Kadnar (2015). For illustrative purposes only. Past performance does not guarantee future performance. Please read important disclosures in the Appendix. 2015 13#14Advice for those that go active (AQR 250/635#15Be More Patient Even good managers have a decent chance of underperforming over 3 year horizons Even if we know a manager has a performance edge over another, it is still very likely that the "better" manager could underperform over multi-year horizons E.g., assume two managers have active returns with 5% volatility each and 0.3 correlation. There is still a greater than 30% chance for the manager with a 1.5% annual return edge to underperform the other, even over 3 years! Probability of Manager 1 Outperforming Manager 2 Manager 1 Expected Outperformance 0.0% 0.5% 1.0% (AOR 1.5% 2.0% 2.5% 3.0% 1 50.0% 53.4% 56.7% 60.0% 63.2% 66.4% 69.4% 3 50.0% 55.8% 61.5% 67.0% 72.1% 76.8% 81.0% Time Horizon (Years) 5 50.0% 57.5% 64.7% 71.5% 77.5% 82.8% 87.2% 7 50.0% 58.8% 67.3% 74.9% 81.4% 86.8% 91.0% 10 50.0% 60.5% 70.4% 78.9% 85.7% 90.9% 94.6% Interesting factoid: Historically, a strategy that systematically invested in the stocks with the best performance over the next five years still experienced a nontrivial amount of risk. This "un-investable perfect foresight" strategy had a realized volatility of 22%, maximum drawdown of 76%, and 10 drawdowns greater than 20% ¹. Would you have the patience to stick with this strategy? 1 "Ev en God Would Get Fired as an Active Investor" Wes Gray and Jack Vogel. Alpha Architect. 2 Feb 2016. https://alphaarchitect.com/2016/02/02/even-god-would-get-fired-as-an- activ e-investor/. The sample used in this study included the 500 largest NYSE NASDAQ AMEXfirms from 1927 to 2016. "Best" was defined as the top decile based on five-year performance. 251/635 Source: AQR, Alpha Architect. For illustrative purposes only. 15#16Invest in Thoughtful Performance Attribution Manager outperformance could be due to style biases, not security selection 11) View Intraday Main View Port Model Factor based Item Portfolio Benchmark 8 4 Holdings Summary Total Return 12.39 3.30 Active 9.09 Click a number to see breakdown Total Return(Active) 12 10 12) Actions - 13) Settings - Trade Simulati Characteristics Tracking Error/Volatility Country Factor Contributors Factor 1. Style: US Momentu 2. Style: US Growth (AOR Trends VS Unit 3. Industry: US Softwar (1) 5 Notices SPDR S&P500 Percentage Return Factor Selection Effe 12.85 Industry Top 6 Factor Contributors Active Exp 1.09 3.78 9.07 1.64 0.43 by GICS Sectors in USD Risk Model US Equity Fundam Click chart bars to drill down -0.46 -0.48 0.01 Style VaR Australia 61 2 9777 8600 Brazil 5511 2395 9000 Europe Japan 81 3 3201 8900 Singapore 65 6212 1000 Country 3.48 3.49 -0.01 Factor Rtn Factor Cont 5.77 6.77 4. Sty 4.49 5. Style 2.66 2.89 1.27 6. Style: Scenarios 44 20 7330 7500 Ge U.S. 1 212 318 200 SN 255480 E Time Custo Factor Group Return Contribution Industry -1.40 0.38 -1.79 Returns (%) 11 Portfolio Benchmark Active 9 7 1 -1 -3 Don't pay alpha fees for alternative beta Performance Portfolio & Risk Analytics Attribution 12/31/14 Style 10.70 -0.11 10.81 Currency Time Return 0.02 0.02 0.00 Return Contrib 07/31/15 0.00 0.06 Total Return 12.39 3.30 9.09 Country ● Exposure Return Factor 12.85 3.78 9.07 Holdings-based attribution for a catalyst- driven, fundamental equity manager Industry Selection -0.46 -0.48 0.01 Country Industry 3.48 -1.40 Style Factor Group Return Contribution 3.49 -0.01 0.38 -1.79 FX/Other Style 10.70 -0.11 10.81 FX/Other 0.08 0.02 0.06 Selection Effect Source: AQR, Bloomberg. Charts are for illustrative purposes only. Not to be construed as a recommendation or investment advice. Notre presentative of a portfolio that AQR currently manages. 252/635 16#17Key Takeaways ● ● ● ● ● Sharpe's arithmetic does not doom external managers to underperformance... ...which could explain the positive average long-term alphas we document... ...but those positive average alphas may also reflect managers' reporting biases Historically, large institutions have had better active performance Dusty corners of financial markets may be more conducive to finding alpha Recent disappointment of active large-cap U.S. equity managers may reflect a bad (and good) draw in typical structural tilts more likely temporary If you go active, make sure to invest in high quality attribution and remember to be patient (AOR Source: AQR. 253/635 17#18Appendix (AQR 254/635#19References Berk, J. B., and van Binsbergen, J.H. (2015), Measuring Skill in the Mutual Fund Industry, Journal of Financial Economics, 118(1), 1-20. Bollen, N.P.B., Joenvaara, J., and Kauppila, M. (2017). Hedge Fund Performance Prediction, SSRN working paper. BlackRock Viewpoint: Novick, B., Cohen, S., Madhavan, A., Bunzel, T., Sethi, J., Matthews, S. (2017). Index Investing Supports Vibrant Capital Markets. Constable, N., and Kadnar, M. (2015). Is Skill Dead, GMO white paper. Dyck, A., Pomorski, L. (2011). Is Bigger Better? Size and Performance in Pension Plan Management, SSRN working paper. Dyck, A., Lins, K., Pomorski, L. (2013). Does Active Management Pay? New International Evidence. Review of Asset Pricing Studies 3 (2), 200-228. Garleanu, N. B., & Pedersen, L. H. (2017). Efficiently In efficient Markets for Assets and Asset Management, forthcoming in the Journal of Finance. Jones, C.S., and Mo, H. (2017). Out-of-Sample Performance of Mutual Fund Predictors, SSRN working paper. Jones, R.C., and Wermers, R. (2011). Active Management in Mostly Efficient Markets. Financial Analysts Journal 67(6), 29-45. Kosowski, R. (2006). Do Mutual Funds Perform When It Matters Most to Investors? U.S. Mutual Fund Performance and Riskin Recessions and Expansions." SSRN working paper. Leippold, M., and Rueegg, R. (2018). Fifty Shades of Active and Index Alpha, SSRN working paper. Mauboussin, M. J., Callahan, D., and Majd, D. (2017). Looking for Easy Games: How Passive Investing Shapes Active Management. Credit Suisse Global Financial Strategie s. Parikh, H., McQuiston, K., and Zhi, S. (2018). The Impact of Market Conditions on Active Equity Management. Forthcoming in the Journal of Portfolio Management. Pedersen, L. H. (2018). Sharpening the Arithmetic of Active Management. Financial Analysts Journal 74(1), 1-16. Sharpe, William F. (1991). The Arithmetic of Active Management, Financial Analysts Journal 47(1), 7-9. (AOR 255/635 19#20Index Definitions Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. The Russell 3000 Index is a market cap weighed index that seeks to be a benchmark for the entire US equity market and is composed of the 3000 largest US traded stocks. The Russell 2000 Index is a market capitalization index that is designed to measure equity market performance of the 2,000 smallest companies in the Russell 3000 Index. The S&P 500 Index is a market-capitalization weighted composite of the 500 largest stocks in the U.S. stock market. The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure the large and mid cap equity market performance of 23 developed countries. AQR 256/635 20#21Disclosures This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information's accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This documentis intended exclusively for the use of the person to whom it has been delivered and it is not to be reproduced or redistributed to any other person. All performance figures contained here in reflect the reinvestment of dividends and all other earnings and represent unaudited estimates of realized and un realized gains and losses prepared by AQR Capital Management, LLC (AQR). There is no guarantee as to the above information's accuracy or completeness. There is no guarantee, express or implied, that long- term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE PERFORMANCE. Diversification does not eliminate the risk of experiencing investment losse s. (c) Morningstar 2019. All rights reserved. Use of this content requires expert knowledge. It is to be used by specialist institutions only. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morning star nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future performance AQR 257/635 21#22AQR 258/635