1. Active, Passive or Enhanced? University of Connecticut
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. Discussion Points Evolution of Indexing Role of Active Management
Structured Management or Enhanced Indexing as an Alternative
Implementation Choices in Asset Allocation

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

4. 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

5. Relative Merits of Passive vs. Active Management
Indexing Active Reason
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. 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

7. 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.

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

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

10. t - statistic of 1.6 implies a 90%
Evaluating Active Management
t - statistic of 1.6 implies a 90%
confidence level
0.5
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?
> T > 10 years T 1 /

11. Skill and Luck More Luck Insufferable Blessed Less Skill More Skill
Doomed
Forlorn
Less Luck

12. 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

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

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.
Large Mid Small
Active Risk, bps
Active Return, bps
Advisory Fees, bps

15. Enhanced Indexing Approaches
Achieve measured, focused and selective departures from index composition
Conventional Strategies - Statistical Arbitrage or Research Enhanced
Downside Suitability for
Strategy Breadth Risk Enhanced Indexing
Stock Selection High Low 
(sector, size, style neutral)
Industry Rotation Moderate Moderate 
Sector Rotation Lower High 
Style Rotation Low High 
Size Rotation Low High 

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 = S&P 500 Plus
(Any Inefficient
Asset Class)
Derivatives arbitrage (eg. stock-index futures, rolling cheap calendar spreads) is now efficiently priced

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

18. Probability of Success Across Investment Strategies
Skill Probability
Investment Strategy Breadth Required of Success
Diversified Active High Lower Higher
Concentrated Active Low/Mod Higher Mod
Style Allocation Mod Mod Mod
TAA, Mkt. Timing Low Higher Lower

19. 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.

20. Market Efficiency and Implementation Choice
Market Recommended Mix
Asset Class Efficiency Passive Enhanced Active
(%) (%) (%)
Large U. S. Stocks High
Small U. S. Stocks Low
Core Int’l. Stocks Mod
Emerging Mkts. Stocks Low
U. S. Bonds High
Foreign Bonds Mod
Emerging Mkts. Debt Low

21. 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!