In the fictional world of Star Trek, cadets at Starfleet academy are forced to captain a starship in a simulation called the Kobayashi Maru. It was set up to test the character of potential captains, since it was literally impossible to save the innocents and survive. Despite being created to be a no win simulation, James T. Kirk beat the test. Of course, Captain Kirk didnt play by the rules and re-programmed the simulation to win…
In today’s equity investment environment, pension plans face their own version of the Kobayashi Maru: choosing between active and passive management. Invest passively and accept the uninformed stock choices of opaque index committees or inflexible index rules. Invest actively and experience lower returns net of fees, far too often. To provide a better alternative, however, forward-thinking asset managers can rewrite the rules, like Captain Kirk, to provide hybrid portfolios that combine the benefits of both active and passive strategies by leveraging quantitative techniques.
Before explaining the mechanics of such a hybrid solution, lets define some key terms: (apologies to my regular readers as several of these overlap with the definitions in my last post)
Alpha – Outperformance or underperformance of a specific asset or set of assets compared to the returns of a benchmark index. Another definition of alpha is idiosyncratic or “stock specific” returns as opposed to market returns
Beta – Correlation in both magnitude and direction to the chosen benchmark index. Note that a stock can have different betas to a broad index, such as the S&P 500, then it might have to its sector index. Both relationships can be called beta, although the most common is the correlation in terms of magnitude to the broad index. At the portfolio level, the deviation of the funds overall correlation to a benchmark index is also called tracking error.
Risk – For this discussion, risk is defined as over or under exposure to fundamental factors such as style (growth / value), asset size (market capitalization), or specific sectors.
Passive Management — A management style where the optimal portfolio is determined by the provider of the benchmark index; a passive managers job is to create and maintain a portfolio that delivers the returns of the index.
Active Management – A management style where the optimal portfolio is determined based upon the decisions of a portfolio manager (PM) or portfolio optimizer (for quantitatively managed funds). The PM selects a portfolio of assets that they believe will outperform the benchmark from within a defined investable universe. For this note, I am defining active management exclusively as long only as many pension funds restrict their fund managers from either shorting stock or employing leverage, and consider hedge funds that do either as a separate asset class.
Hedge Fund Management – This is an extremely broad category of management styles, but, for this discussion, we will focus on three types:
- Equity long/short or absolute return funds – Such funds use the risk-free rate as their benchmark, seeking to earn positive investment returns without exposure to an equity index. Such funds typically maintain both aggregate and sector beta neutrality in their portfolio, unless they incorporate other strategies, and these funds also typically employ leverage to boost returns. Such funds are focused on individual equity alpha, and seek to maximize the capture of their alpha predictions.
- Global macro funds – This management style, often using futures or ETFs to implement their investment decisions, generates profit by market timing various asset classes, geographies, sectors, and styles. Such funds are focused on beta and seek to maximize the capture of their beta predictions.
- 130/30 funds – This is a specific management style where the manager seeks to deliver at least 100 percent of an underlying equity benchmark and has the flexibility to improve those returns by overweighting (by 30% or more) the long positions they believe will outperform and short (30% or more) the stocks they believe will underperform.
Explanation of Management Styles by Example
To provide context for how a hybrid fund can operate optimally, consider an example of a pension plan who has decided to invest in large cap U.S. equities on a well-diversified basis. In this example, the plan is looking for a portfolio with relatively low sector or style risk compared to their benchmark, but will tolerate tracking error to gain outperformance. The fund has three basic choices of managers to hire: all active, all passive, and a combination of both.
Active Management – Active managers, broadly speaking, construct their portfolio by choosing specific stocks which they believe will outperform and then adding stocks to the portfolio to control risks and tracking error. The result, quite often, is a portfolio that holds a large % of asset in similar weights as the index they are benchmarked to. This phenomenon is often referred to as closet indexing[1] and is not an optimal solution. Despite the large overlap between many active portfolios and passive funds, the active managers charge fees much higher than passive managers on the entirety of the portfolio, instead of on the active bets made. In addition to the fee issue, many active managers have separate processes that value and select assets, construct portfolios, measure risks, and trade. These processes should be integrated to maximize returns.
Unfortunately, this level of integration is often absent and performance can suffer for a myriad of reasons. To explain some of the potential issues that can result from poor coordination between processes, consider the following:
- Asset Selection and Portfolio Construction – PMs that are unaware of index weights could size positions either too small or too large to reflect their expectations of asset performance.
- Portfolio Construction and Risk Monitoring — PMs that do not consider asset correlations when establishing positions, could inadvertently force risk managers to rebalance the portfolio to a larger degree than anticipated.
- Asset Selection and Trading — PMs that do not supply the trading desk with predicted alpha, make it difficult for the trading desk to know how aggressive to trade orders.
- Portfolio Construction and Trading – PMs that do not incorporate predicted trading costs when choosing position sizes, risk oversizing those positions and incurring excessive entry and exit costs.
- Trading Mechanics – Active managers that do not trade differently when capturing predicted alpha, rebalancing portfolios to reduce risk, or managing inflows and outflows risk serious performance shortfalls. Trading a stock to capture predicted alpha should be benchmarked to the market adjusted price that the portfolio manager utilized in making the prediction. It is also important to understand the predicted timeframe for that alpha to be realized when determining how aggressive the trading process should be. Trading to manage risk, however, is often a coordinated buy and sell list that is best managed holistically. Trading a cash inflow, however, should mirror the techniques of passive managers who leverage the closing auction of the primary listing exchange to minimize slippage risk.
Passive Management – Passive management has been growing dramatically; Moodys projects that passive assets will overtake active assets by 2024[2] . This trend makes a lot of sense when considering the relative performance of todays active and passive funds, but passive investing as a long-term strategy is only ideal if the investor believes in the random walk theory, which holds that all investment information is always priced into the market. If, however, an investor believes that research driven stock valuation, human insight, quantitative analysis of fundamental or econometric data, factor analysis, or technical indicators can find undervalued or overvalued assets, then passive investing is not optimal.
Active and Passive– The third option would be a bifurcated approach where the fund hires an index fund to manage a large percentage of the assets and an active manager to seek outperformance on the remainder. Hiring a long only manager alongside a passive manager, however, is suboptimal for a couple of reasons. First, the managers expertise is only being partially utilized. If a manager is being hired due to their expertise in identifying stocks primed to outperform, they also likely could identify stocks in the index that will underperform. Since those stocks would be held by a different manager, there is no way to take advantage of such predictions without shorting stock (and most long only managers cant short stocks by mandate). Second, it is difficult to optimize the combined portfolio for various risks as there is no coordination between the portfolios. This could cause the active manager to include stocks in their portfolio without predicted alpha to offset sector or style risks, even if that risk was not significant compared to the combined portfolio.
The Active/Passive Hybrid Solution
The way to build a hybrid management solution with active and passive components is to borrow processes from passive, active and hedge fund managers.
- Passive Managers – Use passive managers index mirroring and trading processes to manage inflows and outflows.
- Active Managers – Use research and asset valuation processes from active managers with track records in finding alpha as well as trading processes with a track record in capturing that alpha.
- Hedge Funds / Quantitative Managers – Use quantitative models, portfolio optimization and quantitative trading processes in an integrated fashion as described in the diagram above.
The result would be a fund that could use either human analysts or pure quantitative models or a mix of both, but would ensure that all alpha predictions were expressed both in terms of magnitude and timeframe. The portfolio construction and generation of trade lists would incorporate the index constituent data, correlation data, alpha predictions, cash flows, and predicted trading costs to create three types of trades with different instructions: Risk reducing, alpha capturing (with the prediction specified) and cashflow trades. Instead of shorting stocks, this fund will either underweight or zero weight stocks in the index with predicted underperformance and, to meet pension guidelines, employ no leverage.
The fee structure would charge clients different rates for the passive and active components of the portfolio. The fees would essentially be in line with passive managers for the index like holdings in the portfolio and with active managers or hedge funds for the active holdings. Such a structure can also be priced on a performance basis with managers earning a percentage of excess returns generated in addition to a passive management fee.
Such a fee structure will almost certainly work out to be less than that of traditional asset managers, even if the active portfolio holdings are charged higher fees. As an example, if a hybrid manager charged 20 basis points for the passive holdings and 2% for the active component, and 80% of the portfolio was passive, the total blended fee would be 56 basis points, which is well below the average for active management.
If managers adopted this methodology and offered hybrid funds, they would be able to end the false dichotomy between active and passive management that is now accepted. Long term investors that believe in the ability of active managers to find alpha would have an alternative that would be more cost effective. In addition, the performance of the hybrid manager would be understandable and provide superior information to the reporting available today. Their ability to produce attribution reports that deconstruct their performance into alpha prediction & capture, risks, and trading costs would enable them to demonstrate the sustainability of their returns.
