Download Structured Asset Management

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
Discussion Points

Evolution of Indexing

Role of Active Management

Structured Management or Enhanced
Indexing as an Alternative

Implementation Choices in Asset Allocation
2
Growth of Indexing
1.4

$1.3 trillion in
institutional
indexed assets
$ trillion
1.2
1
0.8
0.6
0.4
0.2
0
Vanguard S&P
500 index fund
has grown 8 fold
in the last 5 years
Equity
Fixed
Income
1995
2000
80
70
60
$ billion

T otal
50
40
30
20
10
0
1990
3
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
4
Relative Merits of Passive vs. Active
Management
Indexing Active
Relative Performance
- Efficient Asset Class
- Inefficient Asset Class






Implementing Asset Allocation 



Relative Costs
Tax Efficiency
Reason
Empirical
Evidence
Low Info. Needs/
Turnover
Style
Reliability
Low Turnover
5
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
6
Role of Active Management

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.
7
Evaluating Active Management


Information ratios provide the litmus test of
active management.
IR =  = Active Return = 

Active Risk
Active = Portfolio - Benchmark

A high information ratio differentiates skill
from luck in active management.
> + 0.5
< - 0.5
Good
Bad
8
Evaluating Active Management
Estimate
t-statistic = Standard Error
IR = , Standard Error of IR = 1/ T
IR > 0.5 implies a top quartile manager
9
Evaluating Active Management
t - statistic of 1.6 implies a 90%
confidence level
0.5
> 1.6
1/ T
T > 10 years
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?
10
Skill and Luck
More Luck
Insufferable
Blessed
Less Skill
More Skill
Doomed
Forlorn
Less Luck
11
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
12
Evolution of Asset Management
Styles
Expected Return Payoffs
Relative to Benchmark
Share of Enhanced
vs. All Indexing
10.0%
4 to 8%
8.0%
30
6.0%
4.0%
30%
25
1 to 3%
2.0%
20
0.0%
-0.1 to -0.3%
-2.0%
10
-1 to -3%
-4.0%
15
< 5%
5
-6.0%
-8.0%
0
-4 to -8%
-10.0%
Conventional Active
1995
Structured
Asset Class
Less
Exposure
Reliable
More
Reliable
Reliable
Value Added
More
Reliable
Reliable,
but zero
Less
Reliable
2000
Purely Passive
13
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
14
Enhanced Indexing Approaches
Achieve measured, focused and selective departures from index
composition
Conventional Strategies - Statistical Arbitrage or Research Enhanced
Breadth
Downside
Risk
Suitability for
Enhanced Indexing
Stock Selection
(sector, size, style neutral)
High
Low

Industry Rotation
(sector, size, style neutral)
Moderate
Moderate

Lower
High

Low
High

Strategy
Sector Rotation
Style Rotation
15
Enhanced Indexing Approaches
Portable Alpha Strategies (Tracking Error 1 to 3%):
LIBOR Plus
+
Futures S&P 500
=
S&P 500 Plus
Market Neutral
Long-short
+
Futures S&P 500
=
S&P 500 Plus
Convertible
Arbitrage
+
Futures S&P 500
=
S&P 500 Plus
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
16
Importance of “Breadth”
in Active Management
Information Ratio = Skill . Breadth*
IR = IC
.
BR
IC = Information Coefficient
BR = Number of Independent Bets per Year
IC
BR
IR = IC .
Stockpicker
0.05
200
0.71, Excellent
Market timer
0.12
2
0.18, Mediocre
*Source: Grinold & Kahn
BR
17
Probability of Success Across
Investment Strategies
Breadth
Skill
Required
Probability
of Success
High
Lower
Higher
Low/Mod
Higher
Mod
Style Allocation
Mod
Mod
Mod
TAA, Mkt. Timing
Low
Higher
Lower
Investment Strategy
Diversified Active
Concentrated Active
18
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.
19
Market Efficiency and
Implementation Choice
Asset Class
Market
Efficiency
Recommended Mix
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
20
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!
21