The Short Story: Using passive products in active portfolios - a holistic framework

What's your perspective on the active vs. passive debate?

Are active and passive investing really two opposite approaches to delivering an investment strategy to clients? The simple answer is a resounding: "NO!"

In spite of its popularity, that type of thinking is at best simplistic in its over-reaching assumptions. When you examine the market's evidence, guided by sound mathematical principles, you find that neither of these approaches is "primary" and the other "subordinate" and neither is "the best." But many investors are following variations of relatively naive strategies that are based on little more than conjecture and opinion. One popular - but flawed - approach is an oversimplified "core-satellite" strategy, where index funds are overlaid with active products, or where certain sectors are invested passively while other sectors are used as active opportunities. Then there is the practice of simply using passive funds to "park" money until finding suitable active funds - the "always active" approach. At the other extreme is the "all-passive-all-the-time" strategy that focus on minimizing expenses, rather than on maximizing returns net of expenses. As we will show, none of these absolutist approaches are optimal.

We will demonstrate that truly-efficient, opportunity-maximizing portfolios are a careful and mix of BOTH active and passive investments. Each has a place in an efficient portfolio, and we will show that this "mixed" portfolio uses active management judiciously, only where it works, and only to the extent that it is really working. And in a truly symbiotic approach, we will see that the passive investments provide the environment where we can maximize the effectiveness of the active investments within a "team" of that includes both active and passive approaches.

A look at the markets over the past 25 years

For this study we created a benchmark comprised of 70% global public equities and 30% global public bonds. We used a mix of familiar indices to represent our strategy, as indicated by the table below. The indices were:

• Russell 3000: US Equity
• MSCI EAFE: Foreign Equity
• Barclays Aggregate: US Bonds
• Merrill Lynch/Bank of America Cash Pay: High Yield Bonds
• World Government Bond Index (WGBI): Foreign Bonds

Our benchmark achieved a strong return with relatively low volatility risk over the past 25 years, demonstrated by a return of 8.01% with a standard deviation of 8.50%.  Effective diversification improved the portfolio's result over the average of its individual assets, which had a return of 7.52% with an average asset risk of 11.95%.

Can we beat this benchmark?

Our evaluation period (1992 - 2016) contained a few very strong market cycles, as well as two of the three most severe market downturns of the past 90 years. We selected active funds with at least 25 years of monthly returns for the study, and in each of the 10 categories of our asset allocation, we included at least 4 active funds along with the corresponding indexes. All fund returns are net of fees, while index returns are reported gross of fees.

Our conclusions (leaving the details for later...)

• Actively-managed funds are best selected as a team. The common practice is stuck in "The Dark Ages" of identifying each category's "star performer" in isolation, relative to its benchmark. Then the winners of this "beauty contest" are simply thrown together to form the portfolio. Any diversification of the active process is simply random. In contrast, the true team approach eliminates 1/2 to three-quarters of manager tracking error while retaining all the alpha.
• Funds must be included by how they actually invest, not by what they call themselves. Fund managers almost never align with their benchmarks' long term sector allocations, size, style and factor exposures. If you ignore this fact and simply "fill the style boxes" you end up with a substantial amount of tracking error that is simply "benchmark misfit" rather than true active management. We see that the naive traditional approach mistakes style for skill.
• Passive investments provide substantial benefits to active portfolios. All of our optimized portfolios benefited from passive exposure.

Other results

• We used actively-managed funds only where active management was working.
• We were more aligned to the benchmark's structural factors: asset class, asset sector, style factors and other factors.
• "Alpha-Tracking Error" portfolios used more passive products than "Total Return-Volatility" optimized portfolios. Both methods achieved the same total return; one minimized total variance, and the other minimized alpha variance.

Guidance on answering "The Big Question"

"When, where and how much passive investments should I use in my portfolio?" The simple answer is: "IT DEPENDS."

1. It depends on your return goals and your market outlook. If your market return outlook is low, and your return needs are high, then active management may be needed to earn returns high enough to meet your financial goals. This limits your use of passive investments.
2. It depends on the individual characteristics of the funds that are available to you. You may have gaps in your list of active funds, or some funds may be unsuitable, or they may be poor performers. This tends to increase your use of passive investments.
3. It depends on how well your funds work together as a team. If your funds have alpha patterns with low correlations to each other, this eliminates a significant amount of active risk while retaining active return. But if funds have "directional alpha" or excess returns driven by common factors, they may contribute too much active risk to make them worth holding. In this scenario, passive investments fill the gap.

A first-hand look at the study results

As noted, our first set of portfolios seek the lowest volatility of total return. The other set earns the same level of return at the lowest volatility of excess return. The first is a traditional "mean-variance" optimization (MVO) while the second set is efficient in terms of excess return (alpha.) As expected, the traditional MVO portfolios take less volatility risk and the "Alpha-Tracking Error" portfolios take less active risk.

Overview of the active portfolios' performance

Over the past 25 years the portfolios outperformed the benchmark, which earned 5.4% over the cash return. Together these provided investors with returns from 8% to 11%.

Results relative to different views of risk

Here we see the the same level of active return (from 8.5% to 11.0%) but with two different views of risk. The MVO portfolio takes less volatility of total return than the Alpha-TE portfolio. At lower levels of return, this difference in volatility risk is large: 7.0% vs 8.5% for the same 8.5% total return. As we move to higher returns, this difference narrows.

All portfolios - across both optimization methods - needed passive investments to minimize risk in delivering their target returns.

The MVO portfolios used between 17% and 47% passive, a range of 30 percent. The Alpha-TE portfolios used a larger amount of passive products, and employed them over a much greater range, from 71% down to only 11 percent.

Next, let's view these portfolios in terms of Tracking Error risk. The advantage shifts to the Alpha-TE portfolios, which take substantially less active risk than the MVO portfolios. On average, the Alpha-TE portfolios take 200 bps of tracking error risk, while the MVO portfolios take 350 bps of active risk, nearly a doubling of this risk.

Bringing this together

Passive investments play a critical role in the success of the active investments. Without passive investments providing market exposure where needed, active investments would not enjoy their maximum alpha diversification benefits. 

Why? Because alpha diversification is largely dependent on the optimal weighting of each active asset in its "team" structure. If you increase this weighting further to fill up a sector allocation, you destroy some of the diversification benefit the asset provides.

Passive products satisfy the need for market exposure, allowing the optimal active weightings to be used. This minimizes tracking error from both structural mismatch as well as from idiosyncratic active selection decisions.

Summing it all up

Active and passive funds can and should be used side-by-side in a complementary and symbiotic relationship. We can expect most active portfolios to benefit by the judicious inclusion of passive products into their mix.