Evaluating Passive and Active Investing

Client Education Resources

What is Passive Management?

Passive Management
Also known as index investing, passive management is an investment strategy that attempts to replicate the returns of an index or benchmark by owning the same assets, in the same proportions, as the underlying index. Passive investing does not seek to capture excess returns, but seeks to match the performance of an index. Exchange traded funds are an example of an investment vehicle that is often passively managed.

Passive Management and The Efficient Market Hypothesis

Passive management rests on the assumption of market efficiency and a concept called the Efficient Market Hypothesis (EMH). EMH, developed by Eugene Fama in 1965, is a cornerstone to the active versus passive debate. It contends that it is impossible to beat the market and suggests that stocks will always trade at a fair value price that reflects all available information at the time of trading. As a result, EMH hypothesizes that no one stock can ever be deemed over- or under-valued at a given point. Modern Portfolio Theory is primarily based on the EMH concept.

What is Passive Management?

Advantages of Passive Management
Diversified, Risk-Controlled Exposure Lower Expenses and Improved Tax Efficiency Competitive Performance

Disadvantages of Passive Management

Market Returns Only No Ability to Defend Against Down Markets

What is Active Management?

Active Management
In contrast to passive management, active management is an investment strategy whereby managers attempt to add value over the returns of an index by picking stocks based on models, insights, and analytical research. Unlike passive managers, active managers will not seek to match the risk and return profile of an index. They believe that markets are inefficient and, as a result, stocks are often mispriced. Active managers try to identify market opportunities and exploit potential pricing inefficiencies to obtain excess return.

Advantages of Active Management

Potential to Beat the Market Potential for Protection in Down Markets

Disadvantages of Active Management

Higher Costs and Fees Risk and Unpredictability
4

Passive Market Share Continues to Rise

Percent Fund Assets for Active, Index and Exchange Traded Funds
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009
88.7% 87.5% 86.8% 85.0% 84.3% 83.5% 82.0% 79.4% 78.5% 1.5% 9.8% 3.2% 9.3% 3.5% 9.6% 4.5% 10.5% 5.3% 10.5% 6.0% 10.6% 7.3% 9.5% 10.2%

10.7%

11.1%

11.3%

% in Active Funds

% in Index Funds

% in ETFs

Source: Morningstar Direct, SSgA Strategy & Research, as of 12/31/2009 Data is US open-end mutual funds and ETFs as defined by Morningstar. Mutual Funds used are exclusive of money market funds and fund of funds.

Expense Comparisons Active, Passive & Exchange Traded Funds

When compared to passively managed investments, average fees for actively managed funds are significantly higher across most asset classes The introduction of exchange traded products has made passive investing even more cost effective
2.00 1.80 Average Net Expense Ratio 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 Large Cap Blend 1.35 0.65 0.48 Large Cap Growth 1.39 1.07 0.41 Large Cap Value 1.30 0.86 0.39 Mid Cap Blend 1.50 0.81 0.45 Mid Cap Growth 1.48 1.37 0.48 Mid Cap Value 1.39 1.69 0.48 Active Funds Small Cap Blend 1.51 0.92 0.53 Passive Funds Small Cap growth Growth 1.62 1.47 0.39 ETF Small Cap Value 1.54 1.47 0.44 Fixed Income 0.98 0.42 0.19 Emerging Markets 1.80 0.84 0.68

International 1.56 0.85 0.51

Active Funds Passive Funds ETF

Source: Morningstar Average Net Expense Ratio for Active funds, Passive Index funds, and Exchange Traded funds by size and style categories, SSgA Strategy & Research, as of 12/31/2009

Short Term: Percent of Active Managers Outperforming in 2009

2009 proved to be a particularly difficult year for active managers as active funds underperformed across most asset classes Former relative strength for active managers in the growth style and smaller cap spaces showed weakness in 2009; while larger caps, value, and fixed income prevailed
Large Blend Large Value Mid Blend
4.1% 7.5% 8.3% 17.4% 61.6% 6.7% 8.4% 8.7% 23.0% 35.1% 84.7% 54.7%

13.5%

Mid Value Small Blend

8.2%

11.3% 11.3%

Small Value International Fixed Income 0%

6.4%

14.8%

20.4%

40.2% 13.4% 24.8% 85.9%

8.6%

10%

20%

30%

40%

50% % Alpha

60% 70% % Outperform

80%

90%

100%

Source: Morningstar Direct, SSgA Strategy & Research Based on Morningstar data for the year 2009. Chart shows the % of active strategies that outperform the corresponding benchmark and the average excess return of the outperforming managers. Mutual fund performance is net of fees; index performance is gross of fees. The following indexes were used as benchmarks: Dow Jones U.S. Total Stock Market Indexes for the respective domestic equities, the MSCI EAFE Index for international equities, the MSCI Emerging Markets Index for Emerging Market equities, and the Barcap US Aggregate Bond Index for Fixed Income. For illustrative purposes only. Past performance is not indicative of future results.

Long Term: Percent of Active Managers Outperforming with Average Excess Return for Outperforming Funds 15 Year Annualized Period
For the 15-year period, the majority of active managers were only able to beat the corresponding benchmark in two categories small cap growth and emerging markets
Large Blend Large Value Mid Blend Mid Value Small Blend Small Value International Fixed Income
1.2% 1.5% 0.9% 17.5% 37.0% 31.3% 29.6% 37.6% 34.4%

1.7% 1.5% 1.1%

1.6% 1.9% 1.2% 28.1%

47.1% 61.3%

1.9% 1.3% 0.5% 11.5%

36.6% 59.5%

0%

10%

20%

30%

40% % Alpha

50%

60% % Outperform

70%

80%

90%

100%

Source: Morningstar Direct, SSgA Strategy & Research Based on Morningstar data for the past 15 years, ending December 31, 2009. Chart shows the % of active strategies that outperform the corresponding benchmark and the average excess return of the outperforming managers. Mutual fund performance is net of fees; index performance is gross of fees. The following indexes were used as benchmarks: Dow Jones U.S. Total Stock Market Indexes for the respective domestic equities, the MSCI EAFE Index for international equities and the MSCI Emerging Markets Index for Emerging Market equities and the BarCap US Aggregate Bond Index for Fixed Income, . For illustrative purposes only. Past performance is not indicative of future results.

A different vantage point: Percent of Active Managers Underperforming

Looking from the other side of the fence, we can see the percent of active managers underperforming the corresponding benchmark, along with their average underperformance of those underperforming funds for a 15 year annualized period.
Large Blend Large Growth Large Value
1.5% 1.7% 1.5% 62.4% 65.6% 70.4%

Mid Blend Mid Growth Mid Value

2.5% 2.1% 1.9% 63.0% 68.8%

82.5%

Small Blend Small Growth Small Value

2.8% 1.9% 1.6% 38.7%

52.9%

71.9%

International Emerging Markets Fixed Income 0%

1.3% 1.0% 1.3% 40.5%

63.4%

88.5%

10%

20%

30%

40%

50%

60% % Underperform

70%

80%

90%

100%

% Avg Underperformance

Source: Morningstar Direct, SSgA Strategy & Research Based on Morningstar data for the past 15 years, ending December 31, 2009. Chart shows the % of active strategies that outperform the corresponding benchmark and the average excess return of the outperforming managers. Mutual fund performance is net of fees; index performance is gross of fees. The following indexes were used as benchmarks: Dow Jones U.S. Total Stock Market Indexes for the respective domestic equities, MSCI EAFE Index for international equities, MSCI Emerging Markets Index for Emerging Market equities and the BarCap US Aggregate Bond Index for Fixed Income. For illustrative purposes only. Past performance is not indicative of future results.

A Closer Look at Fixed Income Active Performance

Historically, active manager underperformance has been most extreme in fixed income, where less than 12% of the managers added value
12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.2% 0.0% High Yield Government % Outperform TIPs* % Avg. Excess Return Municipals 1.1% 0.4% 1.1% 0.5% 4.4% 8.5%

7.7%

Source: Morningstar Direct, SSgA Strategy & Research Based on Morningstar data for the past 15 years, ending December 31, 2009. *TIPs data for the past 10 years, ending December 31, 2009. Chart shows the % of active strategies that outperform the corresponding benchmark and the average excess return of the outperforming managers. Mutual fund performance is net of fees; index performance is gross of fees. The following indexes were used as benchmarks: BarCap US Corporate High Yield Bond Index for High Yield, BarCap US Aggregate Government Bond Index for Government, BarCap US Government Inflation Linked Bond Index for TIPs, BarCap US Municipal Bond Index for Municipals. For illustrative purposes only. Past performance is not indicative of future results.

10

Large Cap Blend Funds Percent of Active Managers Outperforming (1995-2009)

On a year-by-year basis the results vary considerably, ranging from as few as 14% to as many as 87% active managers outperforming the Dow Jones US Total Stock Market Large Cap Index
100% 90% 80% 70% 60% 52% 50% 40% 30% 20% 10% 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 19% 14% 15% 38% 39% 40% 37% 28% 51% 47% 41% 70% 87%

55%

Source: Morningstar Direct, Percent of Large Cap Blend Active managers that outperform the Dow Jones U.S. Total Stock Market Large Cap Index for time periods given. Members of the Morningstar Large Cap Blend Active universe include non index funds in the Morningstar US Large Blend category.

11

Active Funds Inconsistency and Volatility of Excess Returns

The amount of excess return for large cap blend active funds varies considerably from year to year.
Annual Excess Returns for Median Large Cap Blend Funds (Active and Passive)
6.6

8.00 6.00 4.00 2.00 0.00 -2.00 -4.00 -6.00 -8.00

Annual Excess Returns (%)

1.4

1.3

1.5 0.6 -0.2 -0.5 -0.2 -0.8

1.4

-0.9

-0.6 -2.0

-0.7

-0.5 -1.9

-0.7

-0.4

-0.4

-0.4

-1.1 -0.7

-0.5 -1.6

-0.5

-0.5

-0.3

-4.8

-5.4

-8.1 -10.00 1995 1996 1997 1998 1999 2000 2001 2002 Year 2003 2004 2005 2006 2007 2008 2009

Active Fund Excess Returns

Index Fund Excess Returns

Source: Morningstar Direct, Median Annual Performance of Active and Passive Large Cap Blend funds versus the S&P 500 Index. Mutual fund performance is net of fees; index performance is gross of fees.

12

Its Difficult to Outperform Year after Year

In 2004, 38% of active large blend mutual funds outperformed by an average of 2.4%. Of these managers who had outperformed, very few of them had success in consecutive years.

Percentage of Funds Outperforming in Consecutive Years

35.0%

Percentage of Outperforming Funds

30.0%

28.8%

25.0%

20.0%

15.0%

10.0%

9.2% 5.1%

5.0%

0.5%
0.0% 2004-2005 2004-2006 2004-2007 2004-2008

0.1%

2004-2009

Source: Morningstar Direct, percentage Large Cap Blend funds outperforming for year 2004, subsequent percentage of outperformers for the same group of managers for given time periods. Outperformance is relative to the Dow Jones U.S. Total Stock Market Large Cap Index. Members of the Morningstar Large Cap Blend Active universe include non index funds in the Morningstar US Large Blend category. Mutual fund performance is net of fees; index performance is gross of fees.

13

Passive vs. Active: A Decision Framework

Question 1: Do you believe that markets are generally inefficient? Yes Question 2: Do you believe that there are some managers who can consistently beat the benchmark? Yes Question 3: Do you believe that you can find those managers? Yes Active
14

No

Passive

No

Passive

No

Passive

Passive vs. Active: Key Findings

Active Management - appears to be most rewarding in less efficient, less liquid areas of the markets
Over the 15-year period referenced in slide 8, the following active strategies tended to outperform their passive counterparts:
Small cap blend Small cap growth Emerging markets

Passive Management - passive management seems most rewarding in more efficient markets
Over the same 15-year period, the following passive strategies tended to outperform their active counterparts:
Core fixed income Large cap value Mid cap value Small cap value Developed international markets
15

Passive vs. Active: Key Findings

Keep in Mind
Active and passive management investment styles are not mutually exclusive. Sophisticated investors may benefit from incorporating both strategies into their portfolios.

16

Disclosure
FOR PUBLIC USE.
Passive management and the creation/redemption process can help minimize capital gains distributions. Bond funds contain interest rate risk (as interest rates rise bond prices usually fall). There are additional risks for funds that invest in mortgage-backed and asset-backed securities including the risk of issuer default; credit risk and inflation risk. Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. Investments in mid-sized companies may involve greater risks than those in larger, better known companies, but may be less volatile than investments in smaller companies. The views expressed here are those of State Street through the period ended March 31, 2010 and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any State Street investment product. It does not take into account any investor particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. Investment Strategies mentioned are for illustrative purposes only and may not be relied upon as investment advice or as an indication of trading intent on behalf of any State Street product. SPDR is a registered trademark of Standard & Poors Financial, LLC (S&P). No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by S&P. IBG-1650 Exp Date 12/31/2010

17