In today's investment environment, discussions of active vs. passive management often miss the important point that they are not mutually exclusive. Incorporating passive funds into actively managed portfolios can enhance diversification, reduce risk, and optimize returns.
By leveraging a hybrid “team of funds” approach, investors can leverage the best of both strategies to create portfolios that more efficiently achieve their financial goals. In this post, we discuss how passive investing can complement active strategies and deliver better results for both clients and portfolios.
Strong portfolio construction by team of funds
A robust portfolio construction process should be customized to the client's asset allocation and target excess returns. You should also maximize alpha diversification across your portfolio.
This approach has the following advantages:
- Minimize tracking errors By aligning the portfolio's long-term effective exposure to a benchmark
- Equalize each fund's contribution to portfolio alpha and tracking error
- take advantage of relationships Between the portfolio's active return and the market return.
Here is a case study that illustrates this approach. We test the results using all active funds and a combination of active and passive funds.
I selected four asset allocation strategies across global stocks and bonds to represent my clients' range of risk tolerances. We excluded real assets and illiquid investments in favor of public funds, which are the core of most investment portfolios.
Portfolio parameters:
- Strategies range from 50:50 to 80:20 stocks and bonds
- Alpha targets range from a minimum of 50 basis points (bps) to a maximum of 175 bps in 25 bps increments.
This created a 24-team fund.
I maintained diversification and style characteristics across the strategy, with global and developed stocks balanced between value and growth styles. This resulted in a total of 11 minor asset segments.
Table 1: Diversification across asset strategies.
All-active fund performance
All active performance results over 12 years are grouped by investment strategy. The hybrid team-of-funds approach delivered higher returns with lower volatility than the benchmark.
This result was driven by two factors. First, alpha dispersion eliminated most individual fund tracking errors. Second, the slightly negative correlation of each portfolio's excess return with respect to the portfolio's total return subtracts some of its tracking error from its volatility, given the relationship:
Contribution to volatility = Weight * Volatility * Correlation with portfolio return
Chart 1: Fund teams and benchmarks.
I repeated this approach, this time allowing passive funds to be mixed in. Each portfolio was free to hold any funds on our platform, and passive funds were allocated an unlimited amount. The goal was to achieve above-target returns while minimizing volatility risk.
The surprising result is that across all strategies and alpha targets, portfolios that held significant exposure to passive investments replicated the returns of portfolios that held all active funds..
This result corrects the conventional wisdom that passive funds dilute excess returns. The passive/active hybrid portfolios averaged 40% passive exposure and ranged from approximately 10% to 65%, depending on strategy and alpha target.
Graph 2: All-active and hybrid portfolios.
Passive exposure across strategies and alpha targets
Passive funds allow you to be more selective with active investments and choose only the best. These eliminate asset allocation constraints that limit the selection efficiency of active funds. This promotes “alpha diversification” and reduces active risk.
Table 2: Passive exposure.
Key insight: Including passive funds facilitates more efficient selection of active funds.
How passive investing affects active risk
Chart 3 compares the relationship between alpha and tracking error for all-active and hybrid portfolios. Tracking error increases slightly with the total volatility of all active portfolios until an inflection point is reached where risk begins to increase rapidly.
Hybrid portfolios are dramatically more efficient. The active risk of the entire strategy is approximately the same, with only a difference at the highest alpha target. The return to risk line is approximately straight.
Graph 3: Active results for all-active and hybrid portfolios.
Benefits of lowering active risk
Alpha diversification, selective use of passive investments, and unconstrained active fund teams create a combination of factors that produce superior active results. These benefits are consistent across strategies, with hybrid portfolios having lower active risk and higher reliable minimum alpha.
Chart 4 shows the 95% confidence level alpha across all portfolios. The trend lines for all-active and hybrid strategies summarize the improvement contributed by passive funds. On average, this amounts to between 15 bps and 20 bps of excess return.
Chart 4: Reliable alpha values for all-active and hybrid portfolios.
Evaluating hybrid portfolio performance
To illustrate our hybrid performance evaluation approach, we chose a 60-40 strategy with a target alpha of 100 bps.
My decision-based approach focuses on active and passive components in a hierarchical framework.
- Active and passive allocation
- Major asset segments
- Minor asset segment
- funds
My passive allocation is close to an 80/20 mix of stocks and bonds, while my active allocation is a nearly even mix. This has a significantly different impact on long-term allocation performance.
Figure 5: Hybrid portfolio allocation to asset classes within passive and active components.
Active and passive components also have different allocations within stocks and bonds. This is primarily driven by the alpha opportunities that exist in active funds.. It is also affected by the alpha dispersion of all active funds included in our company.
Figure 6: Allocation to major asset segments within passive and active components.
My most detailed passive and active allocation (style level) perfectly explains that I have over 40% of my portfolio assets allocated to passive investments. The total exposure for each asset segment matches the benchmark allocation.
Table 3: Style level assignment across passive and active components.
Key drivers of hybrid portfolio returns
Figure 7 shows the total return and volatility for each performance component. When compared to benchmark returns, active allocation reduced excess returns, while passive allocation contributed to excess returns.
Figure 7: Return and risk of performance components of the hybrid portfolio.
Selection effects are assessed by comparing active fund returns and active allocation. A common approach is to compare active funds to an overall benchmark. This underestimates the true selection benefit we achieved by removing asset allocation constraints from the fund selection process.
Table 4: Performance coefficients of hybrid portfolio.
Contribution analysis to risk-adjusted returns
I start with the contribution to total return and volatility risk, comparing traditional attribution approaches (Table 5) and my active/passive approach (Table 6). These analyzes are two sides of the same coin.
Table 5: Traditional contribution to revenue analysis.
Because the flow of excess returns is negatively correlated with the portfolio's total return, active returns contributed 93 bps of excess return while subtracting 11 bps of volatility.
Table 6: Contribution of the hybrid approach to total return analysis.
Performance attribution for hybrid portfolios
My job is to account for 93 bps of excess return and 52 bps of tracking error.
The information ratio (IR) of 1.79 for the hybrid portfolio is significantly higher than the IR of 1.21 for the all-active portfolio. It quantifies the efficiency that passive funds bring to a portfolio through superior fund selection and low active risk. These results are shown in Table 7.
Table 7: Attribution results for hybrid performance.
The 93 bps excess return includes 39 bps from active asset allocation in the passive portion. This passive allocation also subtracts 28 bps of tracking error. These results indicate a significant positive contribution of passive funds within the portfolio..
The second part of Table 7 presents a more traditional attribution analysis showing the contribution of allocation and selection to excess returns and tracking error. Active and passive allocation contributions cancel each other out as their combined exposure equals the benchmark exposure. This leaves us with the active fund effect, the excess return due to selection.
Dig deeper into tracking error attribution
Minimizing tracking errors is the key to increasing efficiency. The factors that cause tracking error risk are weighting, individual tracking error, and the correlation between excess returns and the portfolio's total excess return. Table 8 shows the complete causal analysis of the portfolio's 52 bps tracking error.
Table 8: Factors of hybrid portfolio tracking error.
Passive portfolio allocation reflects a tracking error of 386 bps and is negatively correlated with portfolio excess return. This reduces active risk by 28 basis points.
Weight (40.5%) * Risk (3.86%) * Correlation (-0.18) = -0.28%
While the active fund had a tracking error of 80 bps, the passive allocation reduced this by 28 bps, leaving the portfolio with a tracking error of only 52 bps.
Important points
The Fund's team approach to portfolio construction is the basis of active efficiency. By introducing passive funds into the mix, we created a set of portfolios with returns and volatility similar to the all-active set, but with significantly improved active efficiency. Some insights into these benefits are discussed.
- Passive funds remove asset allocation constraints that limit the fund selection process.
- The alpha drag from passive funds is more than offset by superior active excess returns.
- Passive exposure reduces active costs.
- Active risk is significantly reduced and active results are more consistent across strategies.
