Presentation on theme: "Active, Passive or Enhanced? University of Connecticut"— Presentation transcript:
1 Active, Passive or Enhanced? University of Connecticut Sandip A. Bhagat, CFAManaging Director, Citigroup Asset ManagementPresident, Travelers Investment Management CompanyPresented atUniversity of ConnecticutStorrs, ConnecticutFebruary 20, 2004
2 Discussion Points Evolution of Indexing Role of Active Management Structured Management or Enhanced Indexing as an AlternativeImplementation 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 ManagementImbalance between size of information advantage and size of active betsAcademic Arguments of Market EfficiencySelf-Fulfilling Prophecy
5 Relative Merits of Passive vs. Active Management Indexing Active ReasonRelative Performance- Efficient Asset Class Empirical- Inefficient Asset Class EvidenceRelative Costs Low Info. Needs/TurnoverImplementing Asset Allocation StyleReliabilityTax Efficiency Low Turnover
6 Potential Risks of Indexing to the S&P 500 Reversal of Size and Style EffectsLower Financial Asset Returns Shift Focus to Active ManagementReversal 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 - BenchmarkA high information ratio differentiates skill from luck in active management.> Good< BadActive ReturnActive Risk
9 Evaluating Active Management t-statistic =IR = , Standard Error of IR = 1/IR > 0.5 implies a top quartile managerEstimateStandard ErrorT
10 t - statistic of 1.6 implies a 90% Evaluating Active Managementt - statistic of 1.6 implies a 90%confidence level0.5If 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 yearsT1/
11 Skill and Luck More Luck Insufferable Blessed Less Skill More Skill DoomedForlornLess Luck
12 Structured Management or Enhanced Indexing As An Alternative Disciplined investment styleProvides reliable asset class exposureAdds value in a risk-controlled processCombines desired attributes of reliability (purely passive) and value-added (purely active) into one styleEnhances asset allocation decision through risk control and value-added
13 Evolution of Asset Management Styles Expected Return PayoffsRelative to BenchmarkShare of Enhancedvs. All Indexing4 to 8%30%1 to 3%-0.1 to -0.3%-1 to -3%< 5%-4 to -8%Asset Class Less More ReliableExposure Reliable ReliableValue 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 SmallActive Risk, bpsActive Return, bpsAdvisory Fees, bps
15 Enhanced Indexing Approaches Achieve measured, focused and selective departures from index compositionConventional Strategies - Statistical Arbitrage or Research EnhancedDownside Suitability forStrategy Breadth Risk Enhanced IndexingStock 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 PlusMarket Neutral + Futures S&P 500 = S&P 500 PlusLong-shortConvertible + Futures S&P 500 = S&P 500 PlusArbitrageMid Cap Alpha Futures Mid cap Futures S&P = S&P 500 Plus(Any InefficientAsset 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 CoefficientBR = Number of Independent Bets per YearBRIC BR IR = IC .Stockpicker , ExcellentMarket timer , MediocreBR*Source: Grinold & Kahn
18 Probability of Success Across Investment Strategies Skill ProbabilityInvestment Strategy Breadth Required of SuccessDiversified Active High Lower HigherConcentrated Active Low/Mod Higher ModStyle Allocation Mod Mod ModTAA, 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 MixAsset Class Efficiency Passive Enhanced Active(%) (%) (%)Large U. S. Stocks HighSmall U. S. Stocks LowCore Int’l. Stocks ModEmerging Mkts. Stocks LowU. S. Bonds HighForeign Bonds ModEmerging Mkts. Debt Low
21 SummaryVarious forms of indexing are likely to dominate in efficient asset classes.Enhanced indexingcombines reliability and value-added to enhance asset allocation decisions andmay represent a cheaper outperformance call optionActive 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!