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Active, Passive or Enhanced? Sandip A. Bhagat, CFA Managing Director, Citigroup Asset Management President, Travelers Investment Management Company Presented.

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Presentation on theme: "Active, Passive or Enhanced? Sandip A. Bhagat, CFA Managing Director, Citigroup Asset Management President, Travelers Investment Management Company Presented."— Presentation transcript:

1 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

2 2 Discussion Points l Evolution of Indexing l Role of Active Management l Structured Management or Enhanced Indexing as an Alternative l Implementation Choices in Asset Allocation

3 3 Growth of Indexing l $1.3 trillion in institutional indexed assets l Vanguard S&P 500 index fund has grown 8 fold in the last 5 years $ billion $ trillion

4 4 Factors Contributing to Popularity of Indexing l Shortfall of Active Management Imbalance between size of information advantage and size of active betsImbalance between size of information advantage and size of active bets l Academic Arguments of Market Efficiency l Self-Fulfilling Prophecy

5 5 Relative Merits of Passive vs. Active Management IndexingActiveReason Relative Performance - Efficient Asset Class  Empirical - Inefficient Asset Class  Evidence Relative Costs  Low Info. Needs/ Turnover Implementing Asset Allocation  Style Reliability Tax Efficiency  Low Turnover

6 6 Potential Risks of Indexing to the S&P 500 l Reversal of Size and Style Effects l Lower Financial Asset Returns Shift Focus to Active Management l Reversal of Self-Fulfilling Prophecy

7 7 l Good active managers deliver consistent value-added relative to a benchmark. l Good active managers will never fall out of favor or go out of style. l Active management should be used in inefficient asset classes. Role of Active Management

8 8 Evaluating Active Management l Information ratios provide the litmus test of active management. IR =   = = IR =   = = Active = Portfolio - Benchmark Active = Portfolio - Benchmark l A high information ratio differentiates skill from luck in active management. > + 0.5Good < - 0.5Bad Active Return Active Risk  

9 9 Evaluating Active Management t-statistic = IR = , Standard Error of IR = 1/ IR > 0.5 implies a top quartile manager IR > 0.5 implies a top quartile manager T Estimate Standard Error

10 10 Evaluating Active Management t - statistic of 1.6 implies a 90% confidence level 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? > 1.6 T > 10 years > 1.6 T > 10 years T1/

11 11 Skill and Luck BlessedInsufferable Doomed Forlorn Less Skill More Skill More Luck Less Luck

12 12 Structured Management or Enhanced Indexing As An Alternative l Disciplined investment style l Provides reliable asset class exposure l Adds value in a risk-controlled process l Combines desired attributes of reliability (purely passive) and value-added (purely active) into one style l Enhances asset allocation decision through risk control and value-added

13 13 Evolution of Asset Management Styles Expected Return Payoffs Relative to Benchmark Asset Class LessMoreReliable ExposureReliableReliable Value Added LessMoreReliable, ReliableReliablebut zero 4 to 8% -4 to -8% 1 to 3% -1 to -3% -0.1 to -0.3% Share of Enhanced vs. All Indexing < 5% 30%

14 14 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. LargeMidSmall Active Risk, bps Active Return, bps Advisory Fees, bps

15 15 Achieve measured, focused and selective departures from index composition Conventional Strategies - Statistical Arbitrage or Research Enhanced DownsideSuitability for StrategyBreadthRiskEnhanced Indexing Stock SelectionHighLow  (sector, size, style neutral) Industry RotationModerateModerate  (sector, size, style neutral) Sector RotationLowerHigh  Style RotationLowHigh  Size RotationLowHigh  Enhanced Indexing Approaches

16 16 Enhanced Indexing Approaches Portable Alpha Strategies (Tracking Error 1 to 3%): LIBOR Plus+Futures S&P 500 =S&P 500 Plus Market Neutral+Futures S&P 500 =S&P 500 Plus Long-short Convertible+Futures S&P 500 =S&P 500 Plus Arbitrage 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

17 17 ICBRIR = IC. Stockpicker , Excellent Market timer , Mediocre Information Ratio=Skill. Breadth* IR= IC. IC = Information Coefficient BR = Number of Independent Bets per Year Importance of “Breadth” in Active Management BR BR *Source: Grinold & Kahn

18 18 SkillProbability Investment StrategyBreadthRequiredof Success Diversified Active HighLowerHigher Concentrated Active Low/ModHigherMod Style AllocationModModMod TAA, Mkt. TimingLowHigherLower Probability of Success Across Investment Strategies

19 19 Passive vs. Active: Role of Market Efficiency l Active management can be futile in efficiently priced markets (by definition). l Markets are generally efficient in the longer term but may provide short-term opportunities to exploit mispricing. l Emphasize active management in inefficient asset classes.

20 20 Market Efficiency and Implementation Choice MarketRecommended Mix Asset ClassEfficiencyPassiveEnhancedActive (%)(%)(%) Large U. S. StocksHigh Small U. S. StocksLow-3070 Core Int’l. StocksMod Emerging Mkts. StocksLow-2080 U. S. BondsHigh Foreign BondsMod Emerging Mkts. DebtLow-2080

21 21 Summary l Various forms of indexing are likely to dominate in efficient asset classes. l Enhanced indexing combines reliability and value-added to enhance asset allocation decisions andcombines reliability and value-added to enhance asset allocation decisions and may represent a cheaper outperformance call optionmay represent a cheaper outperformance call option l Active management can add significant value in inefficient asset classes by exploiting superior information. l Good active management, if you can find it, will always be in demand!


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