Active, Passive or Enhanced?

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Nov 18, 2013 (3 years and 11 months ago)

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Active, Passive or Enhanced?


Sandip A. Bhagat, CFA


Managing Director, Citigroup Asset Management

President, Travelers Investment Management Company

Presented at

University of Connecticut

Storrs, Connecticut

February 20, 2004

2

Discussion Points



Evolution of Indexing


Role of Active Management


Structured Management or Enhanced
Indexing as an Alternative


Implementation Choices in Asset Allocation

3

Growth of Indexing


$1.3 trillion in
institutional
indexed assets



Vanguard S&P
500 index fund
has grown 8 fold
in the last 5 years

0
10
20
30
40
50
60
70
80
1990
1995
2000
$ billion

0
0.2
0.4
0.6
0.8
1
1.2
1.4
Total
Equity
Fixed
Income
$ trillion

4

Factors Contributing to

Popularity of Indexing



Shortfall of Active Management


Imbalance between size of information advantage and
size of active bets


Academic Arguments of Market Efficiency


Self
-
Fulfilling Prophecy

5

Relative Merits of Passive vs. Active
Management



Indexing

Active

Reason

Relative Performance


-

Efficient Asset Class





Empirical


-

Inefficient Asset Class






Evidence

Relative Costs






Low Info. Needs/





Turnover

Implementing Asset Allocation






Style





Reliability

Tax Efficiency






Low Turnover

6

Potential Risks of Indexing

to the S&P 500




Reversal of Size and Style Effects


Lower Financial Asset Returns Shift
Focus to Active Management


Reversal of Self
-
Fulfilling Prophecy


7


Good

active managers deliver consistent
value
-
added relative to a benchmark.


Good

active managers will never fall out of
favor or go out of style.


Active management should be used in
inefficient asset classes.

Role of Active Management

8

Evaluating Active Management


Information ratios provide the litmus test of
active management.


IR =




=




=









Active = Portfolio
-

Benchmark


A high information ratio differentiates skill
from luck in active management.



> + 0.5

Good



<
-

0.5

Bad



Active Return


Active Risk







9

Evaluating Active Management




t
-
statistic =


IR =

,

Standard Error of IR = 1/


IR > 0.5 implies a top quartile manager

T


Estimate

Standard Error



10

Evaluating Active Management


t
-

statistic of 1.6 implies a 90%

confidence level




0.5






If it can take more than 10 years to
confidently

identify a
skilled

active manager, how long would
it take to identify a
lucky

or
incompetent

one?


> 1.6 T > 10 years


T

1

/



11

Skill and Luck

Blessed

Insufferable

Doomed

Forlorn

Less Skill

More Skill

More Luck

Less Luck

12

Structured Management or Enhanced Indexing

As An Alternative


Disciplined investment style


Provides reliable asset class exposure


Adds value in a risk
-
controlled process


Combines desired attributes of reliability (purely
passive) and value
-
added (purely active) into one
style


Enhances asset allocation decision through risk
control and value
-
added

13

Evolution of Asset Management
Styles

Expected Return Payoffs

Relative to Benchmark



Asset Class

Less

More

Reliable


Exposure

Reliable

Reliable



Value Added

Less

More

Reliable,



Reliable

Reliable

but zero

-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
Conventional Active
Structured
Purely Passive
4 to 8%

-
4 to
-
8%

1 to 3%

-
1 to
-
3%

-
0.1 to
-
0.3%

Share of Enhanced

vs. All Indexing

0
5
10
15
20
25
30
1995
2000
< 5%

30%

14

Expectations From Enhanced Indexing


Enhanced indexing represents a middle ground
relative to passive and active management in terms
of active risk, active returns and advisory fees.



Large

Mid

Small

Active Risk, bps

100
-
200

200
-
300

300
-
400

Active Return, bps

50
-
100

150
-
180

150
-
300

Advisory Fees, bps

10
-
25

25
-
50

50
-
70


15

Achieve measured, focused and selective departures from index
composition


Conventional Strategies
-

Statistical Arbitrage or Research Enhanced




Downside

Suitability for

Strategy

Breadth

Risk

Enhanced Indexing

Stock Selection

High

Low



(sector, size, style neutral)

Industry Rotation

Moderate

Moderate



(sector, size, style neutral)

Sector Rotation

Lower

High



Style Rotation

Low

High




Size Rotation

Low

High




Enhanced Indexing Approaches

16

Enhanced Indexing Approaches

Portable Alpha Strategies (Tracking Error 1 to 3%):


LIBOR Plus

+

Futures
S&P 500

=

S&P 500 Plus

Market Neutral

+

Futures
S&P 500

=

S&P 500 Plus

Long
-
short

Convertible

+

Futures
S&P 500

=

S&P 500 Plus

Arbitrage

Mid Cap Alpha
-

Futures
Mid cap

+ Futures
S&P 500

= S&P 500 Plus

(Any Inefficient

Asset Class)

Derivatives arbitrage (eg. stock
-
index futures, rolling cheap calendar
spreads) is now efficiently priced

17


IC

BR

IR = IC
.


Stockpicker

0.05

200

0.71, Excellent

Market timer

0.12

2

0.18, Mediocre



Information Ratio

=

Skill
.

Breadth*



IR

=

IC
.


IC = Information Coefficient

BR = Number of Independent Bets per Year


Importance of “Breadth”

in Active Management


BR


BR

*Source: Grinold & Kahn

18




Skill

Probability

Investment Strategy

Breadth

Required

of Success


Diversified Active

High

Lower

Higher

Concentrated Active

Low/Mod

Higher

Mod

Style Allocation

Mod

Mod

Mod

TAA, Mkt. Timing

Low

Higher

Lower

Probability of Success Across
Investment Strategies

19

Passive vs. Active:

Role of Market Efficiency


Active management can be futile in
efficiently priced markets (by definition).


Markets are generally efficient in the
longer term but may provide short
-
term
opportunities to exploit mispricing.


Emphasize active management in
inefficient asset classes.

20

Market Efficiency and
Implementation Choice



Market


Recommended Mix


Asset Class

Efficiency

Passive

Enhanced

Active




(%)

(%)

(%)

Large U. S. Stocks

High

40

30

30

Small U. S. Stocks

Low

-

30

70

Core Int’l. Stocks

Mod

30

30

40

Emerging Mkts. Stocks

Low

-

20

80

U. S. Bonds

High

30

40

30

Foreign Bonds

Mod

20

30

50

Emerging Mkts. Debt

Low

-

20

80

21

Summary


Various forms of indexing are likely to dominate in efficient
asset classes.


Enhanced indexing


combines reliability and value
-
added to enhance asset
allocation decisions and


may represent a cheaper outperformance call option


Active management can add significant value in inefficient
asset classes by exploiting superior information.


Good active management, if you can find it, will always be
in demand!