ENHANCING EFFICIENCY WHILE LOWERING ACTIVE COSTS

EXPANDING THE OPPORTUNITY SET

Our “Team of Funds” concept makes the best use of a platform of active funds. How? By selecting complementary funds that offset each other’s short-term weaknesses while maximizing their contributions to the efficiency of the overall portfolio. This creates the opportunity to minimize active risk while maximizing active return through “alpha diversification.”

But what about passive investments that simply deliver a market return at a low cost? Do these have a place in our active portfolio? If so, where should these be used, and how much should we include in the active/passive mix? And what should we expect from adding passive funds to our team of active funds? Will we be forced to accept lower excess returns as we try to control active risk and lower expenses? Or… is it reasonable to expect that adding passive investments may open opportunities for even better active results?

We examine this compelling and controversial topic, and answer these questions by including passive investments in our “team of funds” approach. You might be tempted to think of these “passives” as “zero alpha/zero tracking error” funds that simply deliver market exposure. This case study will show that there is much more to it than that!

OPTIMIZING THE FUND TEAMS BY INCLUDING PASSIVE INVESTMENTS

Our study of passive investments began with the set of 4 asset strategies and 6 alpha targets used to create our “all-active” fund teams; these 24 portfolios were showcased in our earlier articles on portfolio construction. This next step involved optimizations that included passive funds from the 11 segments of each portfolio. By using the same fund platform, asset allocation, style allocation and alpha targets, we isolated the passive factor as the single driver of any differences in performance between our “All Active” fund teams and our “Hybrid” teams that include passive funds.

We started with a good fund platform, from which we had created all-active portfolios that met our active goals. This seems like a challenging environment to test the value of adding passive funds to the investment mix. Any passive funds must earn their place in the portfolio by increasing its active efficiency.

It is a common perspective to view portfolios on a straight line between all-passive and all-active. That approach assumes that any hybrid portfolio sacrifices active return for the safety of an allocation to assured market returns. This viewpoint assumes that there is always a loss of active opportunity when passive funds are introduced. We will test that premise.

FIRST OBSERVATION: HYBRIDS MATCH ALL-ACTIVE RESULTS

Our asset allocations ranged from 50% equity and 50% bonds to 80% equity and 20% bonds. The alpha targets within each allocation were between 50 bps and 175 basis points, increasing in increments of 25 basis points. Working toward these goals, we created a second set of portfolios, this time using both active and passive funds. There were no constraints on which asset segments used passive funds, nor how much could be allocated to passive investments. The optimizations were guided only by the goal of minimizing active risk within each solution.

Not surprisingly, the All-Active and the Hybrid portfolios shared about half of their active funds; the other half were “opportunistic” in either portfolio. This reflects our goal of customizing each fund team to the strategy and alpha targets set by the client. In all cases, we followed our goal of maximizing active efficiency by minimizing active risk for each solution.

We begin our evaluation with total return results, comparing compound return with volatility risk. We clearly see that our Hybrid portfolios achieved essentially identical results as our All-Active portfolios in terms of risk-adjusted total returns.

That is a surprising and compelling insight! Is this the “Black Swan” that explodes the narrative that adding passive exposure necessarily lowers total return and active return? We believe so.

SECOND OBSERVATION: ALPHA TARGET DRIVES PASSIVE EXPOSURE

As expected, we allocated more to passive investments at lower alpha targets, while allocating more to active investments at higher alpha targets. The alpha target was the greater driver of the allocation to passive investments, while the differences in passive weightings across asset allocations were more modest. We calculated the average of the passive weightings across the strategies to estimate our overall use of passive investments at each alpha target. For our case study we found that the optimal use of passive investments was between 1-in-5 dollars (at the highest alpha target) and 2-out-of-3 dollars for the lowest alpha target.

Our case study shows passive investments playing a significant role in actively-managed portfolios, providing a lower-cost approach to achieving the same expected return with the same level of volatility risk as the all-active approach. This may be a counter-intuitive conclusion, and so we will investigate the drivers behind these results.

THIRD OBSERVATION: PASSIVE HELPED ALL ASSET SEGMENTS

We selected the 60-40 strategy and 100 bps alpha target as most representative of the passive exposure we observed across our 24 hybrid portfolios. Its 40% allocation to passive funds was spread across all segments of the portfolio.

Passive investments found their way into almost every sector in almost every portfolio. Only the highest alpha target solutions excluded a few passive options. This is consistent with our earlier observation that passive exposure generally declined as alpha targets reached their upper limits.

FOURTH OBSERVATION: GREATER ACTIVE CONSISTENCY

We turn now to our active results, focusing on alpha and tracking error. This is where passives really shine!

Our process used passive investments opportunistically to achieve our goal of minimizing tracking error at each target level of alpha. Intuitively, we know that this encourages us to use active funds where they perform best. Our selection of active and passive funds differs with each asset allocation and alpha target. But across every solution, we expect to select those active funds that produce the greatest “alpha efficiency” – determined by equalizing their contributions to active return and active risk.

When active funds do not provide enough alpha to justify their contribution to active risk, passive investments could fill that gap in delivering the asset allocation. This leaves the portfolio focused on “the best of the best” when it comes to including active funds. The portfolio can now deliver its asset strategy using active investments, passive investments, or a mix of both.

As noted in our earlier paper, there is a clear relationship between portfolio volatility and tracking error. This is demonstrated in our all-active portfolios, where tracking error increases from about 60 bps to almost 100 bps as our allocations move from conservative (50-50) to more aggressive (80-20) strategies. However, our hybrid results are so consistent across strategies that the chart of their results appears as a straight line.

Clearly, our active results were far more consistent when passive funds were included.

FIFTH OBSERVATION: SUPERIOR ACTIVE RESULTS

Even more striking is the decrease in tracking error at each target alpha as we compare the all-active and hybrid results (illustrated in the prior chart.)

This was most pronounced at the lower alpha range, where the tracking error of the hybrid portfolios was a fraction of the all-active portfolios. For example, at 50-75 bps of alpha, the hybrid portfolio had about 30 bps of tracking error, compared with about 75 bps of tracking error in the all-active portfolios. As a result, all the hybrid portfolios exhibited superior Information Ratios relative to their corresponding active portfolios. The average Information Ratio across all strategies and alpha targets was 1.81 for the hybrids, vs 1.23 for the all-active portfolios – quite a substantial improvement in active results.

In our earlier articles, we had introduced the concept of comparative risk measures, starting with evaluating compensation for active risk vs total risk via our “Information Ratio vs Sharpe Ratio” chart. This compares alpha/tracking error vs risk premium/total volatility. This single chart tracks the trend for these critical risk measures.

We see that these all-active strategies were clearly dominated by the hybrid solutions. In fact, the best results in the all-active strategies were outperformed by the weakest of the hybrid strategies. The positive effects from combining active and passive opportunities were demonstrated across both risk measures.

Enhancing active efficiency produces a higher level of confidence in the active process of portfolio construction. This is clearly illustrated by applying a standard test of confidence to our alpha results, producing a “minimum expected alpha” with a high level of statistical confidence.

We compared our 95% confidence minimum alpha with our expected alpha from our hybrid and all-active solutions. The hybrid solutions delivered 70% of their expected alpha at the 95% confidence level, while the all-active portfolios only delivered 50% of their expected alpha. These results were persistent across strategies and alpha targets, although the degree of outperformance in the hybrid solutions was strongest at the more conservative strategies. This makes intuitive sense, since the alpha is a greater proportion of the total return in more conservative asset allocations.

Superior high-confidence alpha is more easily seen when we average these active results across the strategies.

INSIGHTS REGARDING THE ROLE OF PASSIVE INVESTMENTS

Passives investments have a role to play in active portfolios.

These passive funds provide the opportunity to optimize the selection of active funds more effectively within the context of the total portfolio. Increasing our pool of investment selections lead to a higher likelihood of earning better active results with lower active costs, as compared with portfolios where only active funds are used.

Including passive investments increases active efficiency because it encourages the use of active funds only where they produce their highest result in terms of equalizing contributions to active return and active risk. This more comprehensive approach affects the selection of active funds as well as the allocation to each fund. “Using active only when and where active works best” is a very attractive value proposition for clients, especially in an environment where active fees are under increased scrutiny.

We have demonstrated that adding passive funds via our team process does not lower total returns or active returns. Rather, we showed that our “hybrid” portfolio earned the same returns as in our all-active portfolios, while taking no more volatility risk. We also showed that active risk was better compensated in our hybrid portfolios. We selected the active fund team that contributed best to the portfolio and combined these with passive funds that filled out the asset allocation.

Our “risk aware” approach delivered superior active results with a higher level of confidence in our ability to deliver meaningful alpha to the client – and all this while lowering active costs!

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Written in partnership with Stephen Campisi