Passive V Active - Which is healthy for you? Part 2

When choosing active managers it is very important to distinguish between truly active managers and closet index tracker (active) managers. For example, any active manager that worries about tracking error (the extent to which their portfolio’s returns deviate from the benchmark) runs the risk of being a closet index tracker. Active managers are paid a fee to outperform a benchmark, not to hug it. Consequently, active managers who hold concentrated portfolios are more interesting than overly diversified managers.
It is possible in principle to construct a portfolio comprising of wholly passive products reflecting a particular asset allocation view. Given the importance of asset allocation in terms of investment performance and the relative cost savings of this approach this is not too bad an idea! However, there are areas where the skill and judgement of active managers is necessary. Passive investment strategies only work well when a specific strategy can be codified i.e. reduced to a set of rules that can be implemented consistently. Unfortunately there are some areas that don’t lend themselves to this. Asset allocation is one of them! This is where we believe active managers can earn their fees.
In conclusion, a multi-asset multi-manager’s role is to set the asset allocation for a desired return target and select the best way to implement this view. Where exposure to a particular asset class or investment theme is required looking for a passive alternative is a good starting point. They provide a consistent way to express an asset class or investment strategy view. However, active managers can add outperformance and diversification to this mix and so they should be viewed as a complement. The problem is thus not which approach is better than the other - it is rather one of how much of each an investor should have.
By redefining the concept of active versus passive, institutional investors can have a multi-strategy effect within their investment portfolio by implementing a core-satellite approach. Core strategies are typically those that are well diversified and provide broad exposure to an asset class, while satellite strategies complement a core strategy by providing the opportunity to generate alpha.
Traditional beta is typically best used as a core approach because it results in the lowest tracking error and provides the broadest exposure to an asset class. Conversely, concentrated active is used exclusively as a satellite approach because it has the highest amount of tracking error and typically results in the highest alpha as well. Therefore, a combination of the two should result in a market-like return from the traditional beta strategy complemented by the alpha generated by the concentrated active strategy. Smart beta and diversified active strategies can serve as either core or satellite approaches, depending upon the asset class; however, institutional investors should refrain from using traditional beta strategies as a satellite approach or concentrated active strategies as a core approach. This is because traditional beta strategies do not generate the alpha required of a satellite approach and concentrated active strategies do not provide broad exposure to an asset class because they result in too much tracking error.
Rather than broadly defining active and passive, investors would be better served by differentiating diversified from concentrated within the actively managed portion of their portfolio and traditional beta from smart beta within the passive portion. Doing so should allow investors to better understand the risk and return expectations of each strategy, as defined by tracking error and alpha, thereby allowing these different strategies to be used as complementary solutions within an investment portfolio. This should add value to the portfolio whilst minimising volatility.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]