Quantitative Investment Strategies

February 2017

Indexing and the Evolution of Active Management

Over the past several years, strategies that replicate an equity index have attracted an
increasing portion of investors assets. According to the Investment Company Institute, so-
called passive strategies now represent almost 30 percent of all mutual funds and Exchange
Traded Funds (ETFs); this compares with less than half that amount 10 years ago.1 The trend
towards indexing shows no signs of slowing. Casey Quirk by Deloitte predicts that between
now and 2020, traditional active strategies will lose $1.9 trillion globally while indexed strategies
will gain $1.1 trillion, a shift of $3.0 trillion.2

The popularity of indexed investing has three primary causes: First, many investors are
disappointed with traditional active management. Actively managed portfolios deliver the market
return minus fees and expenses, on average, and skilled active managers are hard to identify in
advance.3 Second, investors are increasingly concerned about costs, which are typically much
higher for traditional active strategies than comparable indexed strategies. And third, a growing
number of investors prefer strategies that are available in an ETF wrapper. Not only are ETF fees
usually lower, but ETFs are transparent, easy to trade, and tax efficient. By construction, most
ETFs track a formal index.

The success of indexing has alarmed some market commentators. Traditional active managers
evaluate each stocks true worth, which then helps determine whether a stock is included in a
portfolio and, if so, at what weight. Managers of indexed portfolios, in contrast, hold all stocks
in proportion to their index weights (more or less), regardless of their fundamental value. As
assets flow from active to indexed strategies, the resources available to support fundamental
research decline, as may the amount of value-relevant information reflected in stock prices. If
indexing becomes dominant, these market commentators wonder who will conduct research and
contribute towards price discovery to ensure markets are (nearly) efficient. In particular, who will
parse companies earnings announcements for insight regarding future performance? Who will
assess a companys prospects for a new product or service? And who will determine the merits
of a corporate restructuring?4

1
Jakab, Spencer. 2016. The passivists: The case for the triumph of passive. The Wall Street Journal (19 October).
2
See White, Justin R. 2016. New arrows for the quiver: Product development for a new active and beta world. Report by Casey Quirk
by Deloitte.
3
See Sharpe, William F. 1991. The arithmetic of active management. Financial Analysts Journal 47 (1): 79.
4
The European quantitative team at Sanford Bernstein argues that an economy dominated by indexing would be worse than a
centrally planned economy. History suggests central planners often make poor investment decisions, but in Bernsteins view, poor
guidance is preferable to no guidance at all. See Sanford C. Bernstein & Co., LLC. 2016. The silent road to serfdom: why passive
investing is worse than Marxism. Fund Management Strategy (23 August). For two opposing views, see Asness, Clifford Scott. 2016.
Indexing is capitalism at its best. BloombergView (2 September), and Malkiel, Burton G. 2016. Is indexing worse than Marxism?
The Wall Street Journal (23 November): A15.
Indexing and the Evolution of Active Management

The concerns captured by these questions are based on the premise that indexed investing
will continue growing to the point where large numbers of active managers are driven from the
market, and indexed investors are left to determine stock prices more or less among themselves.
In our view, a capital market wholly dependent on indexers to determine relative prices would,
indeed, not function well. But is it reasonable to worry that active investing will disappear?

We believe that the threat posed by indexers is overstated. To be sure, we agree that indexed
products will continue to take market share from many types of active products in the immediate
future. However, we believe that active investing will continue to play a significant role in the
economy for many years, and that the potential impact of indexing on the long-term efficiency
of the stock market is minimal. There are three primary reasons for our abiding confidence in
active management.

First, flows in and out of actively managed portfolios provide an incomplete picture of the
quantityor to be more precise, the intensityof active management. What really matters is the
level of disagreement among investors, and the extent to which these investors implement their
distinctive views.5 We believe a managers conviction, as reflected in a portfolios tracking error
(or, alternatively, its active share), provides a more direct indication of a managers contribution
to price discovery.6 Over the past several years, concentrated portfolios, including many hedge
funds, have remained popular while lower risk actively managed strategies have experienced
outflows. As an example, consider activist hedge funds, which pressure companies to change
their corporate strategy and/or capital structure. Activist hedge funds, which take large positions
in a small number of companies, have grown significantly over the past decade even as other
active managers have lost assets.7

Second, many indexed portfolios are, in fact, active. For instance, smart beta strategies,
which have proved popular in recent years, follow well-defined and transparent sets of rules,
and offer exposure to common equity factors such as value, momentum and size.8 A large body
of academic research concludes that portfolios formed on the basis of common equity factors
have delivered higher returns and/or lower risk than the broader (capitalization-weighted) equity
market.9 As smart beta portfolios tilt away from the capitalization-weighted market and towards
common equity factors, they can push stocks towards their fair market value and thereby help
eliminate persistent sources of mispricing, just like other actively managed strategies.10

5
For a formal discussion of the link between disagreement and trading volume, see Harris, Milton and Artur Raviv. 1993. Differences
of opinion make a horse race. Review of Financial Studies 6 (3): 473506.
6
To illustrate the impact of a portfolios risk budget on the potential for price discovery, consider two investors, one who allocates
50% to passive and 50% to a 2% tracking error portfolio, and another who allocates 75% to passive and 25% to a 4% tracking error
portfolio. Although the dollar allocation to active is smaller for the second investor, the amount of active risk in the overall (passive
plus active) portfolio is the same.
7
For an overview of activist investing, including statistics on the level of activism, see Teach, Edward. 2016. Activists at the gate. CFO
Magazine (17 March).
8
For an overview of smart beta strategies, see Alford, Andrew W. 2016. Building confidence in smart beta equity strategies: Common
sense answers to commonplace questions about common equity factors. GSAM white paper (December).
9
For a good overview of the literature, please see Fama, Eugene F. and Kenneth R. French. 2014. A five-factor asset pricing model.
Journal of Financial Economics 116 (1): 122.
10
High dividend stocks have generated strong performance over the past few years, which some market professionals attribute to the
persistent flows into dividend-focused strategies. See Coumarianos, John. 2016. The problem with dividend stocks. The Wall Street
Journal (5 September).

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 Indexing and the Evolution of Active Management

Third, many investors use indexed portfolios to express tacticali.e., activeviews. As

economic conditions evolve, asset allocation models and other outcome-oriented strategies,
for instance, rebalance opportunistically from bonds to stocks, or shift assets among sector
and/or style funds (small cap versus large cap, or growth versus value). The resulting trades can
help eliminate relative mispricing across groups of stocks. ETF strategists use a diverse universe
of ETFs to create multi-asset allocation portfolios, whereas other types of allocation strategies
may include mutual funds or (customized) separate accounts. With multi-portfolio strategies,
the individual stocks within a given portfolio may be weighted according to an index, but stocks
weights in the composite portfolio can deviate significantly from those of the market. In this way,
the overall (combined) strategy is very much active.11

As highlighted above, we do not believe the growth of index investing poses a serious threat
to the efficiency of the capital markets. Although indexed products will likely remain popular
for the foreseeable future, relatively few investors will adopt a pure indexing approach to their
overall portfolio, in our opinion. Rather, we believe investors will continue to build portfolios that
express a variety of active views, either to exploit temporary opportunities in the market, to
dynamically adjust their risk exposures, or simply to better meet their own unique long-term
investment objectives.

The enduring appeal of active investing does not mean, however, that managers of conventional,
stand-alone active equity portfolios can relax. The flows out of actively managed portfolios
are large and persistent, and this is forcing many active managers to justify their investment
methodology. Given these challenges, what should active managers do?

In future, we believe that successful active managers will focus on one or more of the following
key areas:12

Innovation- Investing is a highly competitive activity involving large numbers of talented,

diligent, and nimble players. Success requires deep and unique skills, and a commitment to
stay a step ahead of others. To maintain their edge, some managers will seek to differentiate
their investment process by making greater use of technology designed to process large
quantities of unstructured and alternative sources of data. Such data can include various types
of text, information about web traffic, and video and satellite images. Other managers may
emphasize speed to exploit data more quickly than other market participants. And still other
managers may create new structures such as nontransparent active ETFs, which deliver a
managers investment insights via the convenience of traded funds. Most likely, there is no
single best approach; rather, each manager will need to form his or her own plan, one that
is compatible with the managers specific skills, philosophy, and opportunity set.

Portfolio implementation- Investment insight, as reflected in thorough security analysis,

is a critical component of good performance. But outstanding research is not, by itself,
enough. Efficient portfolio construction and trading is also essential. Investors, even those
with deep and sustainable investment insight, can underperform if their portfolios have
incidental, uncompensated factor exposures that dominate returns. For instance, a high growth
quality portfolio may have large sector exposures that can drive returns even if the stocks
within each sector add value. In addition to portfolio construction, managers need to be mindful
of transaction costs, not just when executing orders but also when selecting stocks and sizing
positions. After all, every basis point saved in market impact is an additional basis point of alpha.

11
Consider the approach adopted by Case-Western Reserve University, as described by their CIO, Sally Staley: In terms of active
versus passive, were looking for alpha in so many places. You may be using passive or indexed return streams, but as you pull those
into a portfolio and combine them, youre seeking to add alpha in that way. Its another technique for getting to a return and beating a
benchmark. See Denmark, Frances. 2016. Meeting of the minds. Money Masters Roundtable. Institutional Investor (July-August).
12
For a more detailed discussion of some of the growth opportunities in the investment management industry, see Boston Consulting
Group. 2015. Global asset management 2015: Sparking growth with go-to-market excellence. BCG Perspectives (7 July).

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Indexing and the Evolution of Active Management

Asset allocation strategies- As explained earlier, some of the flows out of stand-alone active
portfolios and into indexed portfolios reflect a shift in the scope of active management rather
than a decline in the overall quantity of active management. Asset allocation strategies often
use indexed products to express specific investment views, resulting in large deviations from
a pure capitalization-weighted allocation. Active managers can contribute to the growth of
these strategies in at least two ways. First, managers can develop their own asset allocation
models, be they tactical (opportunistic) or more strategic. To be sure, developing an effective
asset allocation model is not easy, and may require that managers expand their expertise, but
doing so could be highly rewarding given the strong demand for outcome-oriented investment
solutions. Second, managers may be able to contribute to the growth of asset allocation
strategies by creating products that are suitable components of a multi-portfolio approach.
Smart beta portfolios, given their transparency and low cost, along with other types of portfolios
that offer well-defined and stable factor exposures, could be suitable building blocks for an
asset allocation strategy.

The steady flows from active to passive products has lead some commentators to conclude that
investors are losing confidence in active management. In fact, we believe investors views about
active management are more nuanced. The strong demand for concentrated (specialty) strategies,
smart beta portfolios, and solutions-based asset allocation products suggests, to us, that
while the scope of active management is evolving, many investors remain committed to active
investing more broadly. As this change occurs, however, many conventional active managers may
struggle. In contrast, active managers who embrace the latest trends, and focus on areas such
as innovation, portfolio construction, and multi-asset strategies, have the potential to do well. For
this reason, we are optimistic about the long-term prospects for active management, and are not
concerned that indexing poses a threat to the proper functioning of the capital markets. Of course,
stock prices do and will deviate from their fundamental values, but if and when mispricings occur,
we do not think it will be due to the growth of indexed investing

Author

Andrew W. Alford
Managing Director, Quantitative Investment Strategies
Goldman Sachs Asset Management (GSAM)

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 Indexing and the Evolution of Active Management

Glossary
Active: Strategy (or investing approach) that aims to outperform a specific index (higher return and/or lower risk).
Active Share: An inverse measure of the overlap between a portfolios holdings and those of its benchmark index. A portfolios
active share varies between zero (the portfolio is identical to the benchmark index) and one (the portfolio has no holdings in common
with the benchmark index).
Basis Point: One-one hundredth (0.01) of a percent. (One hundred basis points is equal to one percent.)
Capitalization-weighted: Index or portfolio that weights stocks by their float-adjusted market capitalization (number of freely
traded shares outstanding multiplied by their per-share stock price).
Fair market value: Transaction price between a willing buyer and a willing seller, where both parties are well informed, and are
acting in their own best interest.
Fundamental value: An objective measure of a stocks economic worth that depends on the companys assets and earnings
potential, and does not rely directly on its market price.
Indexing: Strategy (or investing approach) that aims to closely track the performance of a specified index. See passive.
Low volatility: Stocks that have delivered less volatile returns over the recent past as measured by the standard deviation of stock
returns.
Momentum: Stocks that have generated high relative returns over the recent past.
Passive: Strategy (or investing approach) that aims to closely track the performance of a specified index. See indexing.
Price discovery: Process that relies on the forces of supply and demand (selling vs. buying activity) to determine the price
of an asset.
Quality: Stocks that have experienced strong, persistent profitability.
Smart beta: Strategies that provide exposure to common equity factors via a transparent rules-based methodology.
Tax efficient: Strategies that aim to maximize after-tax returns rather than pre-tax returns.
Tracking Error: Time-series standard deviation of a portfolios excess return relative to the portfolios benchmark index.
Transparent: Extensive information is available about a strategys methodology and performance drivers.
Value: Stocks that trade at a low price relative to measures of intrinsic value.

References
Alford, Andrew W. 2016. Building confidence in smart beta equity strategies: Commonsense responses to commonplace concerns
about common equity factors. Quantitative Investment Strategies, Goldman Sachs Asset Management (December).
Asness, Clifford Scott. 2016. Indexing is capitalism at its best. BloombergView (2 September).
Boston Consulting Group. 2015. Global asset management 2015: Sparking growth with go-to-market excellence. BCG Perspectives
(7 July).
Coumarianos, John. 2016. The problem with dividend stocks. The Wall Street Journal (5 September).
Denmark, Frances. 2016. Meeting of the minds. Money Masters Roundtable. Institutional Investor (July-August).
Fama, Eugene F. and Kenneth R. French. 2014. A five-factor asset pricing model. Journal of Financial Economics 116 (1): 122.
Harris, Milton and Artur Raviv. 1993. Differences of opinion make a horse race. Review of Financial Studies 6 (3): 473506.
Jakab, Spencer. 2016. The passivists: The case for the triumph of passive. The Wall Street Journal (19 October).
Malkiel, Burton G. 2016. Is indexing worse than Marxism? The Wall Street Journal (23 November): A15.
Sanford C. Bernstein & Co., LLC. 2016. The silent road to serfdom: why passive investing is worse than Marxism. Fund Management
Strategy (23 August).
Sharpe, William F. 1991. The arithmetic of active management. Financial Analysts Journal 47 (1): 79.
Teach, Edward. 2016. Activists at the gate. CFO Magazine (17 March).

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Indexing and the Evolution of Active Management

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 Indexing and the Evolution of Active Management

Index Benchmarks
Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect
the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.
The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those
indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to
evaluate the investment or broader market described herein. The exclusion of failed or closed hedge funds may mean that each
index overstates the performance of hedge funds generally.

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Date of first use: February 6, 2017.

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