MASTERCLASS: Active Management: The Power of Choice

In this Legg Mason exclusive MASTERCLASS, a panel of experts joined Asset TV to make the case for active management. Coming from a range of backgrounds, the panelists commented on why active management is underrated, conditions that favor this management style, and the benefits of active despite recent headline risk.

  • Jeff Schulze - Investment Strategist at ClearBridge Investments
  • Adam Petryk - Head of Multi-Asset Solutions at QS Investors
  • Steve Lipper - Senior Investment Strategist at Royce Funds
  • Carl Eichstaedt - Portfolio Manager at Western Asset

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  • 51 mins 44 secs
Gillian (panel moderator): Welcome to Asset TV, I’m Gillian Kemmerer. Every investment portfolio is built around choices, after all no one can afford to or would want to own every security. But should those trades be made mechanically based on the holdings of a pre-set model of the market, like an index, or should they be discretionary, reflecting the expertise in research of a specific firm and portfolio manager? And should they stay the same over time, unaffected by current conditions? Or should they be flexible adjusting to affect changes in the market and macro environment? In short, should those choices be passive or active?

Passive managers have not been shy about touting the virtues of their approach. But today we'd like to hear how four top active managers view the landscape, that includes the positives of active management that may not be fully appreciated by advisors, as well as flaws in the passive approach that merit greater scrutiny.

Welcome to the Legg Mason exclusive Masterclass on active management. Thank you all so much for joining us here today, we're thrilled to have you back. So, Carl, I'm going to start with you. There's research to suggest that whether active or passive outperforms at any give time is actually cyclical. Can you give us a sense of some of the macro conditions that might favor active managers?

Carl Eichstaedt: Sure. First of all I'm very passionate around this subject. And I have quite an advantage over my colleagues here as the fixed income index is much easier to beat than some of the equity indices, over 70% of the index and fixed income is government or government related lower yielding. As markets have become less liquid, I think that the advantage of active management over passive is even increasing. There’s just so many examples of how active has an advantage.

But as we go into this kind of macro environment, you have to be aware of when a security gets kicked in or is out of the index. You have to worry about the ability to trade those securities. From a macro standpoint, a active manager who generally yields more than the index, owns less government securities, wins in three out of four scenarios, spreads tighten, you win, spreads stay the same, you win, spreads widen a little bit, but not enough to compensate for the yield advantage, you also win. So the only time that active managers will generally lose to the index will be a period of extremely risk-off, something like we saw in the crisis.

Gillian: Okay. So in general, active managers in fixed income have the advantage across a range of macro scenarios.

Carl Eichstaedt: I think so.

Gillian: Okay. Steve, you come to us from a small cap perspective, same question to you -- what are the conditions that allow active managers to outperform?

Steve Lipper: Actually I think it's the inverse of much of what we've lived through. So, you know, from our perspective, let’s look at sort of 2011 to 2015. So you had the Fed under a period of extraordinary monetary accommodation which created liquidity, which exceeded what the productive economy needed. So that money's got to go somewhere, and it flowed to the financial economy. When that happens, what you have is, you have the stocks more moved together. So that created an environment which is more challenging for active managers.

The other thing was lower interest rates, so -- lower interest rates tend to reduce the differentiation of better business models and better balance sheets. And those are some of the discriminating factors that active managers will take. Now, the good news for active managers is that we firmly believe that that regime is over. And 2016, at least in small cap, was the beginning of what we think is a multiyear run. We think style also comes into play with that, and we can come back to that.

Gillian: So all those headlines, is active management dead last year, they're immediately null and void, this is a comeback?

Steve Lipper: Yeah.

Gillian: Absolutely, okay. So, Jeff, you are also focused on equities, you're more weighted toward large cap, do you see the same macro forces at play that benefit active management?

Jeff Schulze: Yeah, if you look over the last 50 years you’ve seen this tradeoff between active outperforming and passive outperforming. And there's been four secular cycles that we've seen, but of course passive leading over the last seven years. But once you get to an inflection point, and I believe we did hit one in the middle of 2016, you see that pendulum swing over to the other side for mean reversion. And the key thing to note is that that mean reversion actually happens over a 5 or 10 year period.

And the catalyst this time, in my opinion, is rising interest rates. When you see rising interest rates you usually see higher dispersion between stock participants, industries and sectors. And dispersion is how active managers really create alpha in their portfolios. They can pick the winners and they're going to be compensated for those winning picks.

But if you also think about higher interest rates, a lot of active managers in the large cap space are underweight your bond proxies or your highest dividend-yielders. And that's been a headwind over the last seven years with QE and now, zero-interest-rate policy regimes of The Fed.

But if that now is changing that headwind will now turn into a tailwind. And then the last thing I'll just mention in the large cap space, is usually higher volatility is a good thing for active managers. And you've seen our volatility be picking up here over the last four or five years with greater dispersion, that will create opportunities for active mangers to create value.

Gillian: Okay. So echoing a similar thought that we are poised for a good time for active management, and we'll drill down more into some of the fundamentals driving that in a second. Adam, you come from a multi asset approach, what's your answer to this question?

Adam Petryk: So we don't really think that, you know, active management is cyclical, in the performance cycle as one that again lasts several years as Jeff highlighted. When we actually look at the conditions where active managers tend to well, our perspective is that it's not necessarily just active versus passive, but the types of styles that different active managers might have. We actually think it's a pretty good environment for large cap value in particular, prospectively.

And one of the drivers from our point of view is what we call the effective breadth in the market, which is the number of factors that are driving equity market performance. We see that breadth widening, and from our perspective that's a good environment to be investing in active and in particular in large value.

Gillian: Okay. So more opportunities across factors going into this year?

Adam Petryk: Exactly.

Gillian: Okay. Steve, I'm going to come back to you, I want you to lay it out for me, 2017, what are some the forces at play that could really benefit active managers, particularly within small caps.

Steve Lipper: So the research we did uncovered a connection, we were actually surprised that, and we went through a literature search that nobody had spotted before. So it is widely acknowledged, generally there's active and passive cycles, and actually that there are value in growth style cycles. What we found in small caps is they're actually the same thing. And so specifically we looked at … and this wasn't just our funds, we used industry data; we used Morningstar Small Blend as a proxy for active management. We looked through every rolling five year period back for decades. And here's what we found, we found that when value led actively passive over 80% of the time, and when growth led actively passive only 20% of the time. And first of all it's stunning to know and if you think we're in a value led cycle, which we do, we also think that 2016 was the beginning, at least in small cap of the first year of a multiyear value led cycle. If that's correct, then it's also the first year of a multiyear for active.

Gillian: Okay. And, Jeff, when you're looking at 2017 you alluded to some extra volatility in the market, any other forces at play that are going to positively impact active managers in large caps?

Jeff Schule: Well, I think it all boils down to Fed policy. I would argue that Fed policy is a reason why active in the large-cap equity space has outperformed, because they've suppressed interest rates at the back end of the curve. With Fed policy now reversing, and we potentially will see a balance sheet reduction later this year, that's going to push rates higher and it's really going to help separate the high-quality companies, the companies that have done their due diligence and haven't brought on a lot of leverage, separate themselves from the companies that have thin margins and maybe a little bit more leverage than most investors would be comfortable taking on.

So as their [inaudible] costs rise, I think that really separates the two, and it allows for active managers to take advantage of that. And if you put on top of that the fact that we do have a fiscal policy regime changing with deregulation, you also have lower tax regimes, you also have infrastructure buildouts and some hawkish rhetoric coming out from Trump. I think active managers can take advantage of all of those discrepancies and pick the winners.

Gillian: You've alluded to the Fed, Carl. Obviously I'm sure all eyes are on it from your perspective. So what are some of the opportunities in 2017 you see for active management and fixed income?

Carl Eichstaedt: Well, so the index has a duration of around, let’s say, five years. So if you believe rates are going to rise, and you're an index manager you're kind of stuck with that. We have the ability to lower or raise duration around that target within a reasonable amount. So our view at Western Asset is rates actually don't have to rise that much. There's a lot of cyclical factors that I think are underestimated. If you look around the world, to a German or a Japanese investor whose rates are frictionally zero, our Treasury market looks like a veritable bargain. So I think we're more sanguine about the direction of rates, but having said that, to have the flexibility to move them around that duration of the index is invaluable.

Gillian: Okay. And lastly, Adam, 2017 obviously you've talked a little bit about the number of factors at play, can you maybe give us some specific examples of what we should watch?

Adam Petryk: Well, I think from our perspective, I mean when we think about active versus passive, there's the ability for the underlying managers to outperform, but then there's also the ability for us to add value in terms of our asset class positioning in the portfolios. And we actually are very optimistic on stocks versus bonds in particular in fixed income in 2017. And we're seeing a number of factors in particular, the economy looks pretty strong right now. We're seeing improving trends in employment. The Fed is normalizing policy, but we still see liquidity being ample in the marketplace. And we think those are good conditions for stocks to do well. We're overweight equities in our portfolios, so from an asset allocation perspective, we're taking an active bet, and we think that's an opportunity to add value in 2017.

Gillian: Okay. So obviously markets don't always go up, and we're coming off of the Trump rally of late last year. And actually I think, Jeff, I'll start with you, when does active management add value as markets go down?

Jeff Schule: If you’re looking at large cap performance, active managers add their most value when markets are negative or experiencing some declines, but they also add value in tough markets, markets that are single digit returns. So if you think about that, it all boils down to risk management. Whenever a name is going to go into a portfolio, that portfolio manager is going to vet that name, understand the worst case scenario, and bulletproof the portfolio in case markets do go down, to give you some greater protection when things get a little bit more difficult.

But also if you think about the fact that most active managers have a cash position in their portfolio, as markets goes up, that's a drag on the portfolio, but as markets go down, that helps your relative performance. And the last thing I'll talk about on the risk management aspect of it, is there are times where index sectors get overvalued, bubble-like territories. And you can go back to the 2000s with tech, if you looked at the S&P 500, about 30% was of the tech sector, had technology in it. And active managers that recognized that and were able to make an underweight there, made out handsomely. So if you think about what are the most likely returns over the next couple of years, I think it’s probably a market that sees single digit returns, maybe low double digit returns. But also eventually having a recession where that active management aspect will kick in.

Gillian: Okay. A report from the floor of the New York Stock Exchange and the traders all kind of look up every day, especially in these few weeks and they’re saying, “When’s the correction coming.” So it’s a good opportunity if you have a little bit of a dry powder then.

Adam Petryk: But, Gillian, if I can add, I mean I think that that’s what we all feel as market participants because we’ve been in, you know, this has been a long bull run. So we’re all worried about that potential market correction. But when we look through to the data, you know, when we look through the economic data, even when we think about things like valuations, we still think equities are attractive here. So I think it’s interesting to separate out that emotion from an objective look at the markets, and we still think it’s a good environment for stocks.

Gillian: So, I’m sorry, go ahead.

Steve Lipper: I was just going to build on [that] a little bit. So one of the things that we think is underappreciated about passive, and specifically around market cap indexes is that people don’t recognize, that they’re actually trend following strategies… by weighting something by market cap, you’re actually loading up with today’s most popular stocks. Well, popularity has higher expectations. So how does that manifest itself? Well, when you come to a downturn, when people are getting a little bit more pessimistic about whether it’s economic growth or just the risk tolerance in general, high expectation stocks are more vulnerable. And so that’s why passive, loaded with those more heavily than an active portfoliom, tends to be more vulnerable.

Gillian: Okay, this is a great point. I’m going to come back to this in a second. Adam, before we leave you completely though, I want to know a little bit about how … let’s say we continue to perform well, inevitably there is a market downturn sometime in the future. So how does active add value during that time, no matter how far out it may be?

Adam Petryk: Well, again I think that there’s two ways that we can add value in an active portfolio. Number one is from an asset class positioning, you know, as we can shift the portfolio towards more defensive positions. But then secondly, we expect our active managers to outperform in that kind of environment, because they can be more selective with the types of names that they own. And they’re not beholden to that cap weighted benchmark.

Gillian: Yeah. Great point, we’re definitely coming back, before we go there, Carl, the fixed income perspective, how does active benefit in a downturn let’s say in the fixed income market?

Carl Eichstaedt: Well, not unlike the equity comments here where a rising tide may not lift or lower all boats anymore like it has in the past. That works for fixed income as well. If you asked our analysts how they’re going to make money for our clients, half would tell you that they can make just as much money being short a name as long a name. And I want to give you one example of when a security gets kicked out of the index, it’s a violent transition, particularly in fixed income, particularly with how illiquid the markets have become. One of the largest issuers in the High Yield Index today is Petrobras, the national oil company, Brazil. They were downgraded to junk in November of 15. And the country, Brazil was downgraded in December of 15. The month of January, Petrobras bonds were down 25 points. The index sold at the very bottom, December they were up 15 points. So I would say it was never that bad and it was never that good. But if you’re beholden to being an index fund you had to sell at that point.

Gillian: And I feel like this kind of plays into Steve’s point about some of the issues that are underappreciated with passive management, are there any others particularly in fixed income that you’d want to bring to attention.

Steve Lipper: I’d say the two big ones are the amount of government related debt in the index -- over 70% is either treasury or government mortgage related debt, the lower yielding segments of the market. And secondly, again -- going back to your previous point of the interest rate exposure of the index, around five years, you know, if rates rise 1% and you have a duration of five years, you’ve lost 5% of your capital. I think people forget that bonds can go down in price very easily.

Gillian: Yeah, great point. Jeff, what are some of the things that you find are underappreciated about passive strategies that really need to come to the forefront of the discussion?

Jeff Schulze: I think that Steve has commented on them as well, I think the crowding effect that goes into passive investments, crowding is great on the way up because everybody who invests in an index gets that higher multiple, that higher valuation that that index will have. But then as everybody sells, you see crowding on the way down as well, and that premium evaporates to a lower level, just as quickly as it went up. And I think a lot of passive investors forget that that actually is the case when you’re investing in an index. So one of the risks that I think are underestimated right now in the passive equity space is liquidity. A lot of these investments have come out over the last couple of years and it’s been a liquid market. Maybe not as liquid as some would hope, but nonetheless a liquid market, but those strategies are going to be tested when you see a sustained sell-down over longer periods of time. And my fear is that a lot of these strategies won’t have the liquidity that they think they have right now. And you’re going to see gaps down in the bids and it’s going to hurt the passive investor at the end of the day. It’s not that active investors don’t have the same liquidity constraints. But an active investor who’s been through several market cycles will generally have a cash position to be able to meet redemptions. And then when you get that one up day, because selling doesn’t happen every day, you do eventually get a rebound, the active investor can sell some things at desirable prices, build that cash position and be able to meet redemptions as things continue to go down. So I think liquidity, at least from a passive active perspective is something that’s underestimated by a lot of investors.

Gillian: Yeah, great points all around. Now, Adam, this might seem like a basic question, but is active the opposite of passive? And do these styles have complementary traits that could live together?

Adam Petryk: So we don’t view active necessarily as the opposite of passive. And in fact actually we do believe in putting them together in portfolios. And I think that what we have seen in the past is that a lot of solutions that we’ve created have been either fully active or either fully passive in terms of the underlying vehicles that we buy. But what we are evolving towards is an environment where they can coexist, and in particular where we can use passive is to implement our tactical views, so that we’re not picking up the phone and calling one of our active managers and saying, “Hey, I need to shift out of equities” and selling a portfolio right when they’re saying, “Don’t do that right now.” If I do that with a passive vehicle I can preserve those core strategic allocations to active managers and then tactically tilt my portfolio with cheap liquid passive. And we think that that’s actually a great benefit for investors out there.

Gillian: Okay. So they can coexist?

Adam Petryk: Absolutely.

Gillian: We talked a little bit about some of the risks of passive management that are perhaps underappreciated. I want to talk about some of the aspects of active management on the plus side that are perhaps underappreciated. So, Carl, I’m going to start with you, what in fixed income, what elements of active management do you think investors don’t fully appreciate when they look at your strategy?

Carl Eichstaedt: Again, not unlike an equity investor, issue selection is becoming more and more important as we move into a regime again where a rising tide does not lift or lower all boats. We don’t have to own countries, for example, we don’t like. We don’t have to own Turkey. We don’t have to own South Africa. We’re an index investor, you know, they don’t care where that security goes, as long as they have the index weight.

Gillian: Okay. Steve, same for you, what do you think is underappreciated about active management, some of the benefits?

Steve Lipper: Yeah. So let’s go with the timely aspect, right, because we can have this discussion about, you know, at any point in time, active versus passive, and I would acknowledge that they can have complementary roles within client portfolios. So why active now? And we would make the case for a variety of the reasons that have been cited, that we have shifted from an era of a primacy of asset allocation to a primacy of security selection. Well, if you agree with that, the index has no security selection, i.e. a process that’s endemic to it… if it’s in the Russell, it is 2,000 small cap stocks, just included all. And then if you also think, and our other view is that as it becomes more challenging and some companies do better and some companies do worse, that picking the winning companies or better business models, better management, better balance sheets will generate more value. That’s what we are seeking to anticipate every day. And that’s the advantage that somebody gets with an active manager.

Gillian: Okay. Jeff, I’ll pose the same.

Jeff Schulze: Yeah. I think when you’re buying a passive index you don’t have the ability to load up your portfolio with a low-cost base of stock depending on what happens in the marketplace. You know, if you go back to late 2015/early 2016, energy and materials was a prime example of that. If you owned the index, you know, it came off its highs in 2014, and even though we’ve recovered, you’re still well below where those two sectors had traded at that time. But an active manager can take advantage of that opportunity, buy them when there is weakness, dollar-cost average in, and then hopefully make up some of the ground that they lost back when the initial fall started to happen in 2014. So, that ability to really take advantage of mispricings that occur in the marketplace.

Gillian: Adam, give us a little bit of your perspective here on what you think has been underappreciated about active management?

Adam Petryk: Well, I think that again what investors have underappreciated about active management is the fact that there’s cyclical and then secular components. And I think that people are looking at the cyclical aspect of this and they’re inferring that this is just a one way secular trend. And I think that investors need to be mindful of, you know, why did you hire that active manager in the first place? And if you sort of believe in their strategy you should stick with it, even if we’re facing cyclical headwinds. You know, we all face, as investors, market cycles. Let’s not be our own worst enemies by selling active at a time where it’s at a cyclical low.

Gillian: Yeah. What is that old quote ,labout when the blood is running in the streets, even your own, that’s the time [to buy], so okay, might be applying here. Steve, so much of the discussion of the alpha of active managers has to do with this idea that they have a crystal ball looking into the future. Can you give us a little bit of a sense of how that forward-looking can actually benefit the strategy?

Steve Lipper: Yeah. It really is, active is about anticipating, and anticipating change or appreciating something that’s underappreciated. So let’s contrast that with passive. The benchmark basically says implicitly that things are going to continue at the same pace in the same way forever. There’s not going to be any cycles in market cycles or in product cycles or in supply demand cycles. So let’s contrast it. Well, there’s two different ways that we go against that. In some we will seek to anticipate a turn in a market where there will be, in a particular industry, supply/demand shift that, maybe for example a trucking area, or that maybe in the demand for sensors – electronic sensors in another area. But it can also be that we think the markets under-appreciate the resilience and persistence of a particular mode of a business model. We could analyze and say the market thinks that this company is going to degrade over time that it’s going to become average. But this is really a special company; they have through R&D a market presence, a network effect, a really differentiated business model, that’s going to carry them for a long period in the future. And the current stock price doesn’t reflect that.

Gillian: Fair to say maybe some qualitative aspects of these companies that are not appreciated?

Steve Lipper: Exactly.

Gillian: Okay.

Adam Petryk: And maybe what I can do is actually sort of take what Steve’s talking about from the micro and actually offer a similar perspective from the macro. And one of the things that we do when we think about positioning towards active managers and the types of styles you want in your portfolio is we use a series of environment indicators, where we compare today to relevant historic reference points. And the interesting thing when we look at where markets are today is that it actually looks a lot more like in many respects, sort of the middle part of the 90s rather than necessarily what we’ve seen in terms of that sort of easy money environment that we’ve been dealing with, sort of post the financial crisis. So if you think about the macro environment being quite different, we think that that’s likely a good environment for active managers to add value.

Gillian: So history doesn’t repeat but it rhymes and you have to find the time that it rhymed with.

Adam Petryk: And you have to find the right times, exactly.

Gillian: Okay. And, Jeff.

Jeff Schule: And when investing in an index, you’re really just investing in a momentum strategy. You know, constituents in the index continue to move higher and higher on valuations, but you really can’t take an active view on any particular sector, any particular name. And we all know over full market cycles there’s going to be winners and losers. And usually the winners and losers aren’t the same as the previous market cycle. So being able to go active and be able to make those calls and to be able to forecast what you think was actually going to happen really can help you differentiate yourself as an active manager and outperform if you call them right.

Gillian: Steve, obviously we’ve asked a couple of questions that might seem basic, but I feel like some of the definitions of active versus passive are important. So this one, you know, please help us understand, is passive the same as getting the average? Does it refer to the average returns or would you say that that’s a bit of a misnomer?

Steve Lipper: Yeah. It’s a subtle but important point. And let’s use the Russell 2000, the small-cap index, as an example. So being market cap-weighted doesn’t mean you have the average return of a small cap stock. So let’s use 2015 and ‘16 as an example. We often look at the equal weighted Russell as a measure of breadth. So in 2015 the cap-weighted, the traditional, Russell 2000 was down about 4%...equal weighted was down 10%. That was a tough year for active managers.

Last year it was the reverse, so the cap weighted was up about 21%, the equal weighted was up about 24% -- a much better year for active managers. So the benchmark return itself is not in any way the return of the average stock in that asset class, and people should be aware of that.

Gillian: Okay. So we just talked about the Russell. Now, Jeff, going to you with large caps, would you say again not the same?

Jeff Schule: I would echo Steve’s comments on market cap-weighting playing a bigger factor versus the average stock in the index. And it’s also important to note that not every stock will be represented by, for example, the S&P 500. There’s going to be stocks that happen to be large and mega cap stocks that fall outside that window, but they just don’t make it into the index based on the rules that they have for inclusion there. So I think it would be a misnomer to say that the average return of an index would be, you know, what you should be getting across the asset class.

Gillian: And, lastly, Adam, is there anything that you miss when you think of the index as the average return?

Adam Petryk: Well, I think you do, and I think you miss some of the factor exposures that you get in the underlying index. And I think that we’re touching on those points by thinking about, you know, even the size effect, the value effect and so on. And again, an equal weighted universe might be very different than its cap weighted counterpart. And so you really need to understand what are those active exposures you’re getting in your active manager or in the index, and then should you be positioned towards those?

Gillian: So we focused this question to the equity managers, but in fixed income, would this classification be fair?

Carl Eichstaedt: For sure, I mean the S&P 500, you’ve got to buy 500 stocks, if you want to duplicate the Aggregate Bond Index, we’re talking thousands and thousands and thousands of different bonds, which obviously you can’t buy. So I would argue in fixed income, you not only don’t get any alpha, because you’re not having any issue selection. I don’t even think you can get the beta because you’re buying and selling at exactly the wrong time.

Gillian: Okay. And obviously the risks in the financial markets have changed since the global financial crisis, and particularly for benchmarks in fixed income. So can you talk us through maybe some of the biggest risks that have come to play since 2008?

Carl Eichstaedt: Well, you know, you’ve got again, government and government related debt, almost three-quarters of the index, the lowest yielding securities, US treasuries, it’s a very expensive checkbook to have. They do have a place in any fixed income portfolio, but they have three-quarters of your money there all the time in any environment, you know, over time they’re going to lose. I mean the trailing five year index in the universe that we follow, bond universe, is 99th percentile. So I’m not being a hero saying that fixed income managers should beat the index.

Gillian: Now, Jeff, you run a concentrated strategy, or some of your strategies are more concentrated. Some of the defenders of passive would say that they’re afraid of making these big bets on a few names. Can you talk us through some of the advantages of having that concentrated portfolio?

Jeff Schule: Yeah. So not all active management is created equal, so if you look at all the actively managed large cap companies that are out there there’s about 1,000. But most of them aren’t differentiated. A lot of them are actually closet indexers. And a way to determine whether your manager is truly active is through a measure called Active Share. All that is, it’s the percentage of your portfolio, that’s different than the underlying benchmark. And anything above 70 is considered high active share. And there’s been a famous study that came out in 2009 that showed high active share and concentration were the two features that you wanted your active manager to have, that could produce excess returns. So, you know, those things are the ones that you want to look for and trying to determine whether or not there is an active manager, and whether they’re actually trying to beat the benchmark or just trying to mirror it. And just to give you an example of how important Active Share can be. If we had a large cap core manager with a 1% expense ratio and they only had a 25% active share, for that manager to outperform its benchmark that 25% sleeve of active share would have to generate 400 basis points of excess returns just to justify the management fee. It’s not to say that it’s impossible, but it makes it very hard to do so. So if you point high Active Share and concentrated portfolios together that’s going to give you the best ability to beat the benchmark. But you need to look at it from a risk adjusted return standpoint, because that combination will usually result in higher volatility.

Gillian: So for anyone that’s watching this program, I think you’ve made the point that not all active managers are equal, so due diligence is key?

Jeff Schule: Yes.

Gillian: What are some of the elements that they should look for?

Jeff Schule: Well, look for turnover, how active the portfolio manager is in making decisions. On that study I cited before from 2009, a follow up study came out in 2015, that showed out of the high active share managers, those that traded less or turned over their portfolio more or less often than two years, were the ones that could demonstrate higher alpha generation as well. And then you also want to make sure that they have a robust due diligence process, so in companies making it into their portfolio and of course companies making it out of the portfolio.

Gillian: So I love these concrete examples that you keep giving us. And, Adam, I’m going to move to you. Can you give us let’s say an anecdote or any kind of element that’s happened in your experience in recent years that has really demonstrated for you the benefit of active versus passive?

Adam Petryk: Well, sure and I think that I can give two examples. I mean one specifically is just actually the performance that Western has delivered for our clients in our active portfolios

Gillian: Well done, Carl.

Carl Eichstaedt: Thank you.

Adam Petryk: We’ve seen sort some great outperformance in that fixed income sleeve and it’s been pretty impressive. I think the second example I could give is we had a client who came to us and they were concerned about the equity market, kind of like what we were talking about before about, you know, sort of the duration of the bull run. But they were also concerned about how they would make their own decisions in terms of how to react to different environmental factors. So what they did is they asked us to come in and say, “Hey, could you put a hedging program in place for us that uses our active approach to determine whether they should de-risk or keep the portfolio invested.” As a result we kept them more fully invested in their equity portfolio, given the economic environment, given our macro indicators, and their portfolio has benefitted as a result. So again, I think that there’s two ways that active management can benefit your portfolio, that’s the underlying asset class fulfillment piece, much like, again, Western has delivered for us in a lot of our active portfolios, and then also from that asset allocation perspective. And we can help protect investors against their own worst behavior, I think is one of the best things that we can do for them.

Gillian: That’s a great point, and you’ve been teed up very nicely, Carl, so can you give us an example?

Carl Eichstaedt: Thank you, by the way. I’ve already mentioned the example, when a security is downgraded or upgraded, which I think is an amazing advantage of active or a passive. But also you have the intra month effect. For example, a couple of years ago, Verizon came to market with a multibillion dollar corporate deal, which came a big percentage of the index. We participated in that deal, it was mid month. After the deal broke, syndicated, it was up 6 points. The index buys it on March 31st, up six points. So the index can’t participate in a new issue, can’t do anything intra month.

Gillian: Okay, so speed and ability to be nimble and taking advantage of these opportunities would be a huge opportunity for you. Steve, tell us a little bit about some examples in the small cap space that really benefit active management.

Steve Lipper: Yeah, our most popular strategy is actually one that focuses on protecting on the downside, we are investing in dividend paying small caps. So when we meet with consultants and advisors they’ll often say, “I know I need to have my clients in small cap, but they’re risk averse.” So how do I get that exposure with small cap runs, but sort of protect them a little more when the rainy days come? So a dividend focused strategy within small cap gives you very different exposures than the overall benchmark. And you know, we’ve been managing it for over 20 years and every down market protects you better. So that’s an opportunity we have. An advantage you have in bonds that I’m envious of is if we wanted to buy JP Morgan stock, we have one. They have like 50 different bonds [inaudible].

Carl Eichstaedt: Yeah. You have every different maturity, every different coupon; they all trade at different yields, the ability to find one that’s maybe trading a little less efficiently. Markets are very inefficient today, you know, broker dealers have little or no capital to hold inventory. They act as only principal, not an agent, I’m sorry, only as an agent, not a principal any longer. So the ability to be able to pick and choose amongst the different maturities and coupons is very large, it’s a good point.

Gillian: Yeah. So a big opportunity for you.

Adam Petryk: And I think maybe one other thing I could add in terms of sort of that role of active in a portfolio context is the reality that all of us as investors are going to face is that we’re probably in for a relatively low return world. You know, so with nominal interest rates being where they are, equity valuations, I said we’re bullish on equities, but still they’re fairly full. As a result our market return assumptions have to be lower going forward. So if you’re going to generate that return that investors need it’s our view that active management needs to be part of that overall solution, to generate alpha and also to do things like position portfolios, to take advantage of defensive equity allocations, which is an allocation shift that we’ve made almost across the board in our multi asset portfolios.

Gillian: So, Jeff, I’m going to start with you here, we have let’s say headline risk in every element of financial services, but oftentimes we see active managers painted with the same brush, so looking at the composite results of a range of active managers and calling it, you know, a part to the whole. Can you tell us sort of why that analysis may not necessarily be correct and you’ve already mentioned that not all active managers are built the same.

Jeff Schule: And I would just further that point that there’s a lot of constituents that would make up the active composite that aren’t really differentiated at all. You’re thinking about enhanced indexing, closet indexers where they’re going you close to benchmark returns and not really creating alpha or differentiating themselves. So I think it’s … you need to be very careful in trying to determine, you know, what that benchmark is and what that composite is, and trying to make that assessment.

Gillian: Okay. And, Steve, same question to you, particularly in the small cap space, we’ve had a lot of headline risk let’s say around active management. Can you paint most of them with the same brush or do you find that there’s a huge range?

Steve Lipper: Well, there is a huge range and, you know, perhaps to tout the Legg Mason model a little bit, we think there’s an advantage of being a specialist. Sort of each of our firms is defined and focused around areas where we seek to build compounding advantage by having insights with sustained focus in a particular area. I’m going to go back and we’re going to have a meeting with a small cap bank, we have access to because of our presence in the small cap market. Thousands of company meetings during the course of the year, and we do that over the year. So when we’re meeting with the CFO we can read body language and what they’re talking in tone. I will tell you, there is a total shift in our conversations with small cap managements now, particularly in the cyclical sector as they’re hearing from their clients more optimism, the index can’t capture that. You know, so the advantage of specialization of sustained focus, the insights, the anticipation you get from that, all that’s a part of it.

Adam Petryk: Actually if I could just add on Steve’s comment about sort of that Legg Mason model. We see that real time because we’re allocating to all these different Legg active managers. And one of the interesting things from our perspective is the alpha that the Legg managers generate tends to be pretty uncorrelated. So in other words, again, when Royce is doing well, that might not be at the same time that Western’s doing well, or that ClearBridge is doing well. But over time we’re expecting them all to add value together. And then when we put a diversified portfolio of those active managers that have low correlation amongst each other, you get consistent results, consistent alpha. And we think that that’s a compelling value proposition for the Legg Mason model as a whole.

Gillian: Okay. And, Carl, when you think about the way active managers are painted, let’s say composite versus evaluating individually, do you find that you run into maybe the same issue in fixed income as well?

Carl Eichstaedt: I think it’s underappreciated in fixed income, you know, everyone knows there’s different style differences between equity managers. But there’s big style differences between fixed income managers, some are corporate only, some are mortgage only, some take interest rate risks, some don’t take interest rate risk. So to be a manager like Western Asset which has offices around the globe, which doesn’t pigeonhole itself into being one of those types and concentrates more on the value of the security, I think gives you a big advantage over the index.

Gillian: Okay. I want to take a little bit of time to drill into each one of your areas of expertise. And, Adam, I’m going to start with you because you’ve already alluded to this. What would you say to an advisor or an RIA who’s watching this program and is evaluating how to populate an allocation model with a variety of active and passive strategies, what’s some of the advice you would give to them?

Adam Petryk: Sure, I think probably one of the most important things that I would ask them is to really think hard about what they’re expecting from their different active managers and then what are they expecting from the passive component of the portfolio. Yes, you can get cheap asset class exposure from a passive vehicle. But is that going to be enough to sort of meet your client needs in terms of returns? And then with the active managers, really try to understand what is it that that sort of core philosophy and process that that active manager is delivering for you? What’s the market environment where you expect them to do well versus not? And if you’ve hired an active manager, think about, you know, are you going to stick with them sort of as they go through the performance cycle? And again back to sort of investors and trying to help sort of prevent being our own worst enemies in terms of selling active managers when they underperform. It’s important, if you understand what they’re doing, what their style preferences are, and so on, then you’re more likely to stick with them, you’re more likely to generate returns for your clients in your portfolios.

Gillian: And lastly, in broad strokes, how do you think about the underlying exposures across this variety of managers and strategies?

Adam Petryk: So from our perspective we do two things. Number one, we ensure we get diversification in our portfolios. So we have a quantitative approach towards allocating to the active managers, to ensure that we get that style diversification, so that we’re not beholden to any particular style cycle, except the number two, what we do is we actually take an active view on some of those tilts. And I mentioned that earlier on in the program where right now we think actually large value is a space that’s pretty attractive to us, from an active style perspective we’re relatively more overweight large value managers.

Gillian: Okay, great. And now, Jeff, let’s talk a little bit about impact investing, this is something that you use when you are doing just overlays in your portfolios in general, not just for a specific strategy. When you think about ESG, does it require an active management framework to be meaningful?

Jeff Schule: Yeah, ESG absolutely requires an active framework to be meaningful. You know, if an impact investor wants to put their money to work, you know, they want to make that … the companies that they invest in, implement changes for sustainability or for the better good of the environment or the social or the governance aspect of it. But they inherently think that they need to take a back seat from a return perspective. And that’s a big misconception from a lot of investors. So, ClearBridge, you know, we think we’re in the sweet spot in the ESG space because of our size and our scope. We have a $113 billion in assets under management, which means that corporate level executives want to come and talk to us because we have a big pool of money. But they also want to talk to us because we have a longer framework of investment. So most of our strategies are about 60-70% less than the category average, which means we’re not hot money. So there’s a good chance, 2, 3, 5, even 20 years down the road, we can still be investing with the same company. And from an ESG perspective that’s really important because it’s over those longer timeframes where you really get to know corporate managers where you can institute change. And also with ClearBridge, we don’t silo out our ESG capabilities to a select group of analysts. It’s actually embedded in our entire framework.

So everybody in centralized research assigns a proprietary ESG rating to every company that they cover. At the bottom it’s B, which is uninvestable, but our goal is to get a B company to A, double A, and triple A, which is best in class. And if you’re thinking about that versus passive ESG investing, in order to make it into a passive index, you just check off some arbitrary boxes and you fit the bill and you make it in. But at ClearBridge we can go two, three, four, five layers deep to really help make an impact of that company and help make changes that a passive investor just can’t do. And then the last thing I’ll quickly say about a return expectation, you know, we don’t think you need to give up a return expectation to effect change at a company level. If you look at the benchmarks that we have with our ESG strategies, it’s not a specially arranged ESG benchmark, but they’re actually benchmarked to what non-ESG managers are going up against.

Gillian: So for you ESG is not just a screen to take out companies from portfolios, it’s actually an opportunity to help them grow and move forward?

Jeff Schule: Absolutely.

Gillian: Can you give s a sense of some of those metrics that you’re measuring them on from an ESG perspective?

Jeff Schule: It depends on the company and the industry. But you know, you can look at environmental aspects, social aspects, whether it’s labor laws, whether they lobby, you can go a number of different areas, it’s just depending on the company dynamics.

Gillian: Okay. And, Steve, looking at large cap versus small cap, obviously large cap we often think and associate with passive or index investing. But with small caps, active management has long really been associated with picking out those correct names. So can you give us a better sense of what makes small cap so well suited to this approach.

Steve Lipper: Yeah. I mean the research we referenced earlier that we looked at; Morningstar Small Blend is a proxy for active. If you just take all rolling five year periods, active beats passive two-thirds of the time by over a 100 basis points after fees. So the idea that passive wins all the time is actually factually inaccurate in small cap. Why would that be? Well, we think that there’s a couple of reasons, one is under-coverage, there’s roughly a third of the analysts on the sale side that cover small cap stocks, that cover the large cap stocks. And we have a number of stocks we invested that has no sale side coverage at all, that’s going to create, we think, inefficiency. But the more subtle point is that you have often greater alignment with management, is that you also have about four times as much insider ownership of the average small cap company as the average large cap company. And that’s one of the things that you always have to be concerned about. But if you are investing as an active manager, you are aligning yourself with the management and if their financial interests are aligned with that as well, it has produced positive outcomes.

Gillian: Can you give us a little bit of a sense of the due diligence process for you in a small cap versus a large cap stock?

Steve Lipper: Yeah. So actually we use governance as well as part of our process. But it’s a framework that is trying to gain insight into culture. Because ultimately when you invest in a stock you have to take a leap of faith and trust, right. You’re giving your client’s money to these people to generate value over time. And so we have a manager who has a framework that starts with the accounting. And he looks at accounting to see, can I trust them, how aggressive? If you’re aggressive in accounting, you’re probably aggressive in business practice. Then look at things like the incentive compensation, what are they incenting on? We would rather people be incented on long term results and in the business rather than sort of short term earnings results, we take a look at the quality of people on the board of directors, what is their tenure? What is their background? For example, it’s somebody that’s heading the audit committee, were they formerly an accounting partner or not? So those sort of [inaudible] together that you get the sense of how are they running this company? Can I actually trust them? Is there a good business model, a good balance sheet? But ultimately what’s the culture of this company? So that’s some of the diligence.

Gillian: Perfect, thank you. And, Carl, when we move over to fixed income and we think about unconstrained strategies, what do investors need to think about or know when they’re investing in them versus other types of active investments?

Carl Eichstaedt: Well, first of all it’s very tough to compare unconstrained strategies, unlike a traditional bond fund, which is run against the Aggregate Index, very apples and apples comparison. In the unconstrained area we have people all over the map. So number one, it’s a very difficult comparison. You have to really hone in on what universe you’re looking at. For example, we have two products which are quite a bit different, one concentrates on volatility between 4 and 5%, and one concentrates on volatility between 8 and 10%. The one with less volatility is much more bond like. You know, it has a beta to the bond market, whereas the other strategy has a beta to nothing.

Gillian: Okay. And can you give us a sense of maybe some of the other targets that you look at in these structures?

Carl Eichstaedt: Well, over a long period of time, people … it depends what bucket it comes from. So if you’re a pension plan, are you putting unconstrained in your alternative bucket? Are you putting it in your fixed income bucket? If it’s coming from your fixed income bucket, the board is going to say to the bond market, “Beat this strategy.” So for example, over the last eight years as rates have fallen and stayed low, I think people have been very frustrated with unconstrained strategies because rates haven’t risen. So I think if we do move into a new regime where rates are going to probably march upwards in some degree or another, unconstrained strategies could really come back into favor.

Adam Petryk: And if I can actually just add on that, I mean one of the things we’ve been doing in the multi asset portfolios has been to increase allocations to unconstrained strategies. And part of the premise is again, you’ve got the secular decline in interest rates that’s likely largely behind us. We need more sources of return in our portfolio. We need more uncorrelated sources of return. From our perspective, unconstrained strategies are a great source of uncorrelated return for our portfolios.

Gillian: So even if the Federal Reserve rate hikes are somewhat expected and priced in, you still think they’ll add value throughout 2017?

Adam Petryk: I do.

Gillian: Okay. I want to give each of you an opportunity to give us your final thoughts on why anyone watching this program, particularly the advisors and the audience should consider active management. Obviously they’ve been battered with headlines that would suggest otherwise, but it seems like all of you have made the case that it’s poised for outperformance, so, Carl, starting with you, why active management now?

Carl Eichstaedt: Well, if you look for macro down to micro, all the decision trees we look at, we think there’s just a huge advantage in fixed income, particularly active over passive. On the very top you have your interest yield curve decision, we’re beholden to the five year duration of the index. Second one would be sector allocation, we’re not beholden to this very overweight to treasury and government related mortgages. Then you go down to subsector, even more important within the corporate market, you know, we can be overweight finance and energy and be underweight telecom and pharma where the index can’t.

Gillian: Okay. So you are able to be far more nimble and outperformance is perhaps even easier in fixed income than equity in active management.

Carl Eichstaedt: I think so.

Gillian: Steve, what would you say to this?

Steve Lipper: The advisor retains control actually when you have active. So you can choose what is the risk level that I want to have in our strategy, at Royce we have small caps at different risk parameters. And the second thing is they can choose whether or not they want to have their outlook. So we have some strategies that are more sensitive to economic acceleration than others. So I think when an advisor chooses active they actually do retain more control then they surrender it to the benchmark. I think it’s a very challenging client meeting, when the benchmark goes down by 20, 25, 35% and the client says, “Well, why did that happen? Why did we do that?” Well, why did we put that on autopilot? So I think control and retaining that is important for the advisor.

Gillian: Okay, great point. Jeff, what do you think?

Jeff Schulze: Yeah. And if you think the factors that make an active manager outperform, they’re all prevalent right now. You have higher interest rates. You have correlations that are coming down, higher dispersion between all constituents within an index. You also have volatility starting to pick up here a little bit. And you put on top of that the fact that we’re moving from a Fed driven policy to more of a fiscal driven policy, that’s going to create ample opportunities for active managers to be able to pick those winners and to figure out who’s going to be able to distinguish themselves.

Gillian: Okay. So winners and losers are going to start shaping out, so that’s a great opportunity for active managers, lastly, Adam, obviously you’re allocating across a range of strategies, give us your perspective on this.

Adam Petryk: So I think that there’s two key things to consider when you’re thinking about the active versus passive. Number one, you should consider the fact that there’s a cyclical component to this, so don’t fall prey to the most recent cycle. I think as an investor, that’s one of the things that we can all aspire to do. And I would encourage advisors to do the same. And then the second perspective would be again the returns that you need to generate from your clients. And from our point of view, there’s really sort of two aspects to improving returns from your clients. There is the where and the what. Where is how should your portfolio be positioned from an asset class perspective? And the “what” is, what are the types of strategies you should invest in under the hood? And we think that again, hiring a suite of active managers is one of the best ways to generate returns for your clients.

Gillian: Excellent. Well, that’s a great note to end on here, and thank you all so much for sharing your very varied opinions on active management. But obviously coming to the same conclusion, it seems like now is a very great time to be entering in again. Thank you. And thank you for tuning in. From our studios in New York I’m Gillian Kemmerer and this was the latest edition of Masterclass.

A spread is the difference in yield between two different types of fixed income securities.

High yield, or below-investment grade bonds, are those with a credit quality rating of BB or below.

The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Alpha is a measure of portfolio performance vs. a benchmark, relative to the volatility of that benchmark. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.

Beta measures the sensitivity of an investment to the movement of its benchmark. A beta higher than 1.0 indicates the investment has been more volatile than the benchmark and a beta of less than 1.0 indicates that the investment has been less volatile than the benchmark.

Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change. It is calculated as the weighted average of the present values for all cash flows, and is measured in years.

Mean reversion is a theory suggesting that prices and returns eventually move back towards the mean or average.

The Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index covers the universe of fixed rate, non-investment grade debt, including corporate and non-corporate sectors.


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The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.

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