Exploring the costs and benefits of two alternative investment approaches.

1. Active vs. Passive Money Management
Exploring the costs and benefits of two alternative
investment approaches
By Baird’s Advisory Services Research
Synopsis
Proponents of active and passive investment management styles have
made exhaustive and valid arguments for and against both approaches.
Each has its merits and inherent drawbacks, and this paper will not
endorse one style over the other. Rather, our goal is to define the
characteristics of each approach in an effort to help you determine
which best suits your needs and preferences.
Investors encounter different opportunities and challenges at different
times, which can help determine the investment management approach
that is the best for them. On one hand, we believe active management
can add value when coupled with strict due diligence services. On the
other hand, when limited investment options are available or the best you
can do is “average” performance, passive investment options may make
more sense due to fees and other considerations. Regardless, a clearer
understanding of how to balance and leverage both active and passive
management is crucial to realizing your investment objectives.
The Basics of Active and Passive Management
The proliferation of passive management strategies in recent years is well
documented and evidenced by the exponential growth of the Exchange
Traded Fund (ETF) marketplace. Currently there are more than 800
ETFs available; many of these employ passive strategies and range from
those replicating the widely-recognized S&P 500 Index to more niche
indexes such as the S&P Global Water Index. Passive management has
proven a viable strategy and is challenging the more traditional portfolio
construction practice of investing strictly in active managers.

2. Several factors should be considered As Table 1 shows, there are tradeoffs
when deciding between active and between the costs and potential
passive management. These factors vary benefits of the two approaches. Passive
greatly from one client to another and management will maintain exposure
the solutions can be just as unique, to the market, but not offer any
ranging from a purely passive to purely potential for above-benchmark returns
active approach or some combination (or down market protection). Active
of both. The correct use of these management offers the potential for
strategies can help build a portfolio above-market returns, but comes with
better suited to your specific needs. the chance that the manager won’t
beat the stated benchmark. Also,
Active vs. Passive Management
Defined neither approach can completely
shelter you from the possibility of
The difference between active and below-market returns. These variables
passive investment management and the nuances of your specific
lies primarily in the stated goal situation make this a decision best
and the approach used to reach it. made with the assistance of your
Active management is overseen by Financial Advisor. The remainder
investment professionals striving to of this paper should help guide you
outperform specific benchmarks. through that decision-making process
Passive management (i.e., index ETFs, by offering examples of when, where,
index funds) attempts to replicate and how Baird believes active or
the return pattern of a specific passive strategies should be used.
benchmark. With active management,
investment experts are hired based
Implementation of Active
on the perceived value they can add
and Passive Strategies
above and beyond the benchmark.
Passive management often stresses low Proceeding from the conclusion that
costs, tax efficiency and the concept of both active and passive management
market efficiency. are valid strategies, the question
TABLE 1: becomes where and when is one more
appropriate than the other? The
Passive Management Key Feature Active Management following pages will outline several
Generally lower than active Investment Generally higher than common considerations.
management Management Fees passive management
Depends on the
The Truth of Market Efficiency
Generally tax efficient Tax Efficiency
investment manager Market efficiency is the degree to
Potential for which stock prices reflect all available
No Yes
Above-Market Returns
information. In a perfectly efficient
Potential for
Yes, after incorporating fees Yes market, all stocks are precisely valued
Below-Market Returns
Potential for and no active manager has the ability
No Yes
Down Market Protection to outperform the market. If the
Seeks to replicate the Seeks to capitalize on market were completely inefficient,
Decision Making Process
performance of the benchmark market conditions
nearly all active managers would
be able to succeed. The truth lies
somewhere in the middle.
--

3. For the purposes of this study, several (particularly in large and mid-cap) and
major asset classes were examined to fixed income. Growth styles tend to be
identify the less efficient asset classes that less efficient, as are the satellite asset
are conducive to active management classes, defined as Real Estate, High
and the more efficient asset classes that Yield Bonds, Emerging Markets and
are best suited for passive management Commodities. Other asset classes are
mixed; requiring a judgment call as to
(Table 2). Baird measured the frequency
whether active or passive management
that the median, or average, mutual
would be most appropriate. It is worth
fund in a given asset class was able
noting that, while fixed income is highly
to provide excess return above its efficient, in our opinion there are very
benchmark (second column below). few passive options that merit an
TABLE 2:
investment. Many of these options have
Asset % of Periods Median Efficient (favoring passive) Market short track records and have exhibited
Class Fund Produces or Inefficient (favoring ac- Assets higher-than-anticipated tracking
Excess Return tive) Asset Class (% Active / % Passive)
error. Tracking error is the degree to
Tax-Exempt Fixed Income 4% Highly Efficient 99% / 1%
which returns vary from the actual
Large Value 8% Efficient 9% / 8%
benchmarks, something that passive
Taxable Fixed Income 9% Efficient 79% / 1% investments strive to minimize.
High Yield 5% Efficient 96% / 4%
Our study causes us to question whether
Mid Value 40% Efficient 94% / 6%
the marketplace recognizes that some
Mid Core 4% Mixed 59% / 41% asset classes are more efficient than
Small Value 50% Mixed 8% / 18% others and, therefore, have a distinct bias
Large Core 54% Mixed 46% / 54% toward active or passive management.
Mid Growth 55% Mixed 96% / 4% The best way to measure this is to
International 57% Mixed 69% / 1% determine what percentage of assets in
Large Growth 67% Inefficient 9% / 7% an asset class are invested in active or
Small Core 70% Inefficient 67% / % passive managers (fourth column in
Commodities 7% Inefficient 47% / 6% Table 2). Surprisingly, some of the most
Emerging Markets 75% Highly Inefficient 48% / 5%
efficient asset classes are dominated by
active management (e.g., Large Value
Small Growth 80% Highly Inefficient 89% / 11%
and Mid Value, both over 90% active
Real Estate 90% Highly Inefficient 6% / 7%
assets) and many of the least efficient
asset classes have a bias towards passive
Various one-year, three-year and five- management (e.g., Emerging Markets
year periods were examined over the past and Commodities, both over 50%
15 years, giving us a total of 139 distinct passive assets). This is counter-intuitive
observations per asset class. For example, and leads us to the conclusion that
the median Large Growth fund was many investment portfolios are not
able to outperform its benchmark 67% optimally constructed.
of these periods, making it a relatively All else being equal, it is our opinion
inefficient asset class. Alternatively, the that active management be used where
median Large Value fund outperformed it has the best chance of success, and
passive management be used to round
only 28% of the time, making it a fairly
out the asset allocation. This may
efficient asset class.
lead to an optimal portfolio that plays
Asset classes that tend to be highly into the strengths of the different
efficient include the value styles investment options.
--

4. What Is Average? Clearly, there is a great difference
between average and above-average
In the previous section on market
managers, and this directly influences
efficiency, we focused on the
a client’s ability to meet or exceed
performance of the median mutual
performance expectations. While
fund. In many cases, the evidence is there is no certain way to identify
not a ringing endorsement for active and invest strictly in top-quartile
management. Since no investor managers, the success rates of average
strives to invest with an “average” versus above-average managers
manager, we examined how the makes a strong case for trying to
outcome would change for those identify superior options. Also, it is
invested with a top-quartile manager increasingly difficult for a manager
(i.e., performance that ranks in the to constantly remain a top-quartile
top 25th percentile of the peer group performer over many periods.
universe). For example, the median However, Baird believes that by
large cap manager underperformed conducting thorough research and
due diligence on investment
the benchmark by 20 bps, on average,
managers, it becomes easier to
of all three-year periods included in
identify which of them exhibit
the study, while top-quartile managers
the characteristics associated with
added 230 bps of excess return during consistent, long-term success.
those periods (1 basis point = .01%).
Why Spend Time on Due Diligence?
Average -Year Excess Return by Asset Class
600
500 The success of top quartile
versus bottom quartile
Average -Year Excess Return (bps)
funds makes an investment
400
in due diligence worthwhile.
300
200 Top Quartile Fund
Median Fund
100
0
(100)
Large Cap Mid Cap Small Cap International
Large Cap Mid Cap Small Cap International
Top Quartile 0 70 570 60
Median -0 0 0 80
Source: Morningstar Direct; Baird Analysis.
For the 10-year period ending June 30, 2009, excess returns for individual mutual funds were collected
by asset class. The excess returns were calculated based on rolling 3-year periods (n=29). All performance
is net of the funds’ management expense ratio.
-4-

5. The Due Diligence Process Other Important Considerations which includes lower-priced ETFs that
How professionals choose and track major indices to higher-priced
Below are the other most common
monitor money managers options that track specific sectors or
factors that should weigh into your
industries. Given that ETFs and index
When choosing money managers, decision when choosing a money
funds have similar objectives, in most
it’s clear that past performance manager. These are important topics
cases you would be generally best
doesn’t tell the full story. The to discuss with your Financial Advisor.
process of identifying quality served by utilizing the lowest priced
Investment Time Horizon option available to you.
managers and then monitoring
their performance over time is How soon you need the proceeds from Fees are equally as important when
known as due diligence. In the invested assets to reach specific goals considering active management
legal world, due diligence refers determines that investment’s time options, but the decision is a bit
to the care a reasonable person horizon. Some assets are designated more complicated. First, fees vary
should take before entering into for long-term growth until retirement, more with active management,
an agreement. In the investment
while others may be invested in the but so does manager quality. It is
management world, it refers to
stock market for the short-term, in generally prudent to invest in lower
the deep investigation of a money
lieu of CDs or savings accounts. In priced options because of the lower
manager that takes place before,
either case, the length of the anticipated hurdle, especially in the fixed income
during and after that manager is
recommended to a client.
holding period for those assets can arena, where the performance
help dictate which solution is most spreads are already narrow. However,
At Baird, a team of analysts
appropriate. Baird’s studies have final judgment must be made based
conducts investment manager due
shown that active managers have a on whether you and your Financial
diligence. Their goal is to minimize
higher probability of success if held Advisor believe a money manager
the risk of underperformance by
gaining a full understanding of
for longer periods. For example, the has the requisite talent to earn the
the story behind the numbers. The frequency that a manager adds value fees by providing adequate excess
process is continuous with equal increases from 59% to 79% by return. This is where due diligence
effort applied to manager selection extending the holding period from becomes critical.
and ongoing manager evaluation. 1 year to 3 years. Baird recommends
It includes these steps: allowing at least one full market cycle Tax Sensitivity
1. Initial manager screening of three-to-five years for most active Generally speaking, passive
using a proprietary, multi-factor managers to realize the potential of investments offer investors greater tax
model that encompasses 16 their strategies. For holding periods efficiency because they create fewer
different factors scored over of a year or less, passive management capital gains situations due to in-kind
various times periods can be a quick and effective way to distribution. Also, because of the
. Preliminary and detailed portfolio gain exposure to the market without low turnover of the securities that
analysis, which requires weeks high transaction costs. comprise most of the indices such
of research and numerous funds are modeled after, not a lot of
Investment Management Fees
conversations with the trading is necessary. For active
prospective money manager Management fees are an inescapable managers, however, buying and selling
. On-site visits, which often lead fact of investing. Passive management securities is one way they attempt to
to important observations does generally have lower fees relative add value by capturing excess returns.
that cannot be garnered over to active management, but fees can This can come at the cost of increased
the phone vary greatly even for investments capital gains exposure. For those
striving to replicate the same clients who are very sensitive to taxes,
benchmark. The average ETF expense ETFs can be a suitable option.
(continued) ratio as of June 2009 was 0.54%,
-5-

6. (continued from previous page) Market Conditions Conclusion
Evidence suggests that certain market There is no consensus regarding which
4. Written investment thesis that
conditions favor active or passive approach provides superior results.
consolidates all information
gathered in the prior steps to
management. Actively managed With proper due diligence, active
answer the question, “Why investments have historically performed management has the potential to
should clients invest with better than passively managed provide above-market returns. However,
this manager?” investments when the markets are passive management creates a level of
decidedly negative, or in flat-to- consistency, knowing that investment
5. Committee approvals to
ensure full agreement that moderate markets. Conversely, performance will not vary greatly from
the manager is an acceptable passive investments have generally the benchmark. Before making a
investment option outperformed in swiftly rising markets. decision, it is important to consider your
While there are exceptions to these expected time horizon, tax sensitivity,
6. Ongoing due diligence used
to assess consistency among
dynamics, understanding when market ability to tolerate performance variation
people, process, philosophy conditions are favorable or unfavorable and other factors. Your Financial Advisor
and performance for an investment style is important can help you weigh your objectives and
in managing expectations. concerns to determine which approach
Although it is easy for investors to
access historical performance data,
is most appropriate for you.
deeper information becomes much
more difficult to uncover. A robust
due diligence process can bridge
that gap. Understanding the drivers
of performance can significantly
improve our chances of identifying
high performing managers.
ETFs are subject to the same risks as their underlying securities, trade on an exchange throughout the day and redemptions
may be limited and, if purchased outside of a fee-based portfolio, brokerage commissions are charged on each trade.
Past performance is not a guarantee of future results and no investment, regardless of the length of time held, is guaranteed
to be profitable. Indices are unmanaged and an investment cannot be made directly in one.
Investors should consider the investment objectives, risks, charges and expenses of any fund carefully before investing.
This and other information is found in the prospectus. For a prospectus, contact your Baird Financial Advisor. Please
read the prospectus carefully before investing.
-6-
© 009 Robert W. Baird Co. Incorporated. www.rwbaird.com 800-RW-BAIRD MC-6545 First use: 10/09