Envestnet Whitepapers

2 1 | INTRODUCTION In this latest release of the Active vs Passive Management research, we have updated previous results on Morningstar category classification into "active" or "passive." We first carry out estimations using the entire available data history (for some categories the data start in 1980s), which therefore give us results that hold on average across the whole time period. Second, we produce time trend estimates, which zero in on a particular time period. Our findings show that when using the entire data history for equity asset classes, the active or passive designations remained largely consistent with the previous study. With the exception of large cap growth, the data suggest that domestic large cap asset classes may be passively managed, whereas satellite asset classes (particularly domestic and foreign small cap) could be managed by selecting active managers. Similarly, fixed income asset class designations remained unchanged, with passive management suggested for most categories. Our time trend (or latest period) analysis examines four decades of available performance figures and extracts only the most recent three year data at a particular point, with interesting results. For example, even though the large cap growth asset class is designated as active when looking at the average results over the full time period, recent trends suggest that active managers in that category have had difficulty outperforming. 2 | METHODOLOGY 2.1 | Overview The motivation for using Active vs. Passive methodology for portfolio implementation is straightforward: it is a much easier task to select active managers that add positive alpha 1 from an asset class, where the proportion of such managers is high. This contrasts with identifying a positive alpha manager through the "needle in a haystack" approach in an asset class where this proportion is small. This is especially true if an investor or advisor has not demonstrated an ability to select managers with positive future risk-adjusted returns to begin with. Additionally, as in earlier versions of this research, we have assigned an "active," "passive," and "neutral" moniker to an asset class or a category based on a proportion of positive alpha managers in the peer group (more on this in the next section). However, our cut-offs for these three classifications, although reasonable and defensible, are necessarily arbitrary. That is, what might be an acceptable proportion of positive alpha managers for one investor or advisor to pursue an active strategy in a particular category might seem altogether too low and risky for another. Thus, investors and advisors should consider their unique circumstances and use the calculated proportions of each category's positive and negative alpha managers as a guide for classifying the categories into "active," "passive," and "neutral." Active or Passive Classification This section describes how we calculate the proportion of a category's positive and negative alpha managers. We also, describe a heuristic rule that we employ for those calculated proportions to decide whether a particular category is "active," "passive," or "neutral." FOR ONE-ON-ONE-USE WITH A CLIENT'S FINANCIAL ADVISOR ONLY © 2022 Envestnet. All rights reserved. Skilled Managers: Those whose alpha is above or equal to a statistically significant positive percentile, calculated from ranking all the managers in the peergroup. Alpha: Also known as risk-adjusted return, is equal to the difference between the performance of the manager (MP) and the benchmark (BP), with the benchmark multiplied by the manager's beta. The formula is: A=MP-BP*beta. Unskilled Managers: Those whose alpha is below or equal to a statistically significant negative percentile, calculated from ranking all the managers in the peergroup.

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