{"id":41947,"date":"2015-04-28T07:52:26","date_gmt":"2015-04-28T05:52:26","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/combining-active-and-passive-management-in-a-portfolio\/"},"modified":"2019-12-30T23:37:17","modified_gmt":"2019-12-30T22:37:17","slug":"combining-active-and-passive-management-in-a-portfolio","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/combining-active-and-passive-management-in-a-portfolio\/","title":{"rendered":"Combining Active and Passive management in a Portfolio"},"content":{"rendered":"

In recent years, long-held ideas on portfolio construction have been called into question. Investors
\ncan now choose from a range of \u201csmart beta\u201d strategies, offering exposure to market risk premia
\nin a systematic, transparent fashion. Where does the dividing line between active and passive
\nfund management now lie? What is the likely future role of active managers? And as indices
\nevolve, how should standard, capitalisation-weighted benchmarks be used? In this Expert
\nOpinion, Nicolas Gaussel, Chief Investment Officer at Lyxor Asset Management and Arnaud
\nLlinas, Lyxor\u2019s Head of ETFs and Indexing, share their views on these important questions.<\/strong> <\/em><\/p>\n

TRADITIONAL \u201cCORE\u201d ACTIVE MANAGEMENT IS SHRINKING<\/strong><\/p>\n

[Nicolas Gaussel]<\/strong> One trend that has dominated asset management since
\nthe turn of the millennium is the shift of assets away from traditional \u201ccore\u201d
\nactive mandates.<\/p>\n

According to a 2014 study by Boston Consulting Group (BCG), active core
\nassets represented 63% of global assets under management in 2003, but
\nthis figure is likely to fall to 40% by 2017. Investors worldwide have been
\nmoving away from traditional active management into alternatives, dedicated
\nactive mandates, solutions and liability-driven investment (LDI) schemes.
\nThere is also a big rise of passive funds in allocations, including exchangetraded funds (ETFs).<\/p>\n

\"lyxor-smart-1.jpg\"<\/a><\/p>\n

So we are witnessing a bipolarisation of the asset management market:
\nincreased demand for specialist active management, on the one hand, and
\nfor passive mandates on the other. Traditional active managers are under
\nincreasing pressure to justify their roles.<\/p>\n

PASSIVE FUNDS ARE GROWING<\/strong><\/p>\n

[Arnaud Llinas]<\/strong> In its study, BCG noted that passive
\nmandates and ETFs had grown from $3 trillion to $10 trillion
\nin assets under management between 2003 and 2013,
\nand BCG expects this market segment to continue to grow
\nhealthily. We think there are four reasons for this trend.<\/strong><\/p>\n

First<\/strong>, active managers continue to underperform their
\nbenchmarks in aggregate. According to a recently published
\nstudy by my colleague Marl\u00e8ne Hassine, Lyxor\u2019s Head
\nof ETF Research, only 21% of active funds on average
\noutperformed their benchmark over the last 10 years. And
\nthe evidence also shows that there is little persistency in
\nperformance over time. Managers that beat the benchmark
\nin one year have thus a poor chance of doing the same the
\nnext year.<\/p>\n

\"lyxor-smart-2.jpg\"<\/p>\n

Second<\/strong>, passive funds, including ETFs, have a clear cost
\nadvantage against active funds, leading many investors to
\ndecide that they would prefer to track an index rather than
\nto try and beat it. Of course, it\u2019s fair to point out that passive
\nfunds don\u2019t replicate their indices exactly. Other things being
\nequal, they will trail it by their annual costs of management.
\nHowever, passive funds\u2019 costs are relatively low and have
\nbeen steadily decreasing.<\/p>\n

Third<\/strong>, passive funds now offer access to a broad range of
\nasset classes and with a great degree of granularity, offering
\ninvestors significant choice. Passive funds are typically highly
\ndiversified, giving wide access to individual market segments.<\/p>\n

Fourth<\/strong>, smart beta\u2014investment strategies, codified as
\nindices, with an ease of replication in a systematic, transparent
\nmethod\u2014is an increasingly important phenomenon.<\/p>\n

SMART BETA EXPANDS THE DEFINITION OF PASSIVE<\/strong><\/p>\n

[A.L.]<\/strong> Smart beta is expanding the traditional definition of passive
\ninvesting, and in a way that offers investors a valuable new tool.
\nVarious types of portfolio strategy traditionally undertaken
\nby active investment managers can now be replicated
\nefficiently and at low cost via smart beta indices. In other
\nwords, passive funds are increasingly being used to give
\nexposure to strategies that were historically offered only in
\nan active format. To some extent, smart beta is also likely to
\nreplace some of investors\u2019 traditional allocation to passive
\nfunds, tracking indices weighted by market capitalisation.<\/p>\n

In a recent Expert Opinion from Lyxor[[http:\/\/www.lyxor.com\/fileadmin\/PDF\/20141106-EXPERT_OPINION_RISK_
\nFACTOR_RONCALLI_GB.pdf]], my colleague
\nThierry Roncalli, Lyxor\u2019s Director of Research provided an
\noverview of the concept of risk factors. Risk factors help
\nus understand the performance of equities and other asset
\nclasses, and an increasing number of smart beta indices
\noffer exposure to individual risk factors.<\/p>\n

There are other popular types of smart beta index, including
\nthose focusing on the reweighting of index constituents, on
\nparticular investment styles or on specific risk outcomes,
\nsuch as minimising volatility.<\/p>\n

In the future, we think that many portfolios will include an
\nimportant allocation to smart beta, as well as to traditional
\nbeta and to active management alpha.<\/p>\n

\"lyxor-smart-3.jpg\"<\/p>\n

ALTERNATIVES OFFER UNCORRELATED RISK
\nPREMIA<\/strong><\/p>\n

[N.G.]<\/strong> It may seem paradoxical that the demand for
\nalternative asset management structures, such as hedge
\nfunds, has been increasing in the midst of this boom for
\nindexing and passive solutions.<\/p>\n

But investor inflows into alternatives have been very
\nstrong. BCG estimated in 2014 that alternative assets
\nmore than trebled between 2003 and 2013. Another study,
\nconducted by Cliffwater and Lyxor, found that the weighting
\nof alternatives in US state pension funds has recently more
\nthan doubled, rising from 10% in 2006 to 24% in 2013[[According to a study by Cliffwater and Lyxor AM.]].<\/p>\n

During a period of great volatility in asset markets and
\ndespite the negative headlines associated with some hedge
\nfunds, investors continue to be attracted by alternatives\u2019
\nability to generate attractive risk-adjusted returns.<\/p>\n

Over the period between 2001 and 2014 US equities (the
\nS&P 500 index) and US government bonds (the Citigroup
\nUS GB 7-10 year index) and hedge funds (in the form of
\nthe HFRI index) all gave total returns of around 6% a year.
\nBut while US equities had annual volatility of around 15%
\nover the period, hedge funds had bond-like volatility of
\naround 6%. Hedge fund returns were also negatively
\ncorrelated to bond returns, and only weakly correlated to
\nthose of equities.<\/p>\n

These statistics reinforce the central attraction of
\nalternatives: they can act as an effective portfolio diversifier,
\noffering uncorrelated risk premia. And this results from
\nhedge funds\u2019 exposure to non-traditional asset classes.<\/p>\n

\"lyxor-smart-4.jpg\"<\/a><\/p>\n

ALTERNATIVES AS TRUE ACTIVE MANAGEMENT<\/strong><\/p>\n

[N.G.]<\/strong> Increasingly, alternatives are being seen as the true
\nhome of active asset management. Hedge funds are often
\nrelatively unconstrained in the investment positions they
\nare allowed to take. By contrast, in many traditional core
\nactive management mandates performance is measured
\nrelative to an index benchmark, and managers may be
\nreluctant to depart too far from index weightings. The
\ndifference between traditional active mandates and hedge
\nfunds is also supported by a lot of academic research.
\nFor example, in 2009 Professors Ang, Goetzmann
\nand Schaefer reviewed the performance of the active
\nmanagement of the Norwegian Government Pension
\nFund, which was largely based on traditional mandates[[https:\/\/www.regjeringen.no\/globalassets\/upload\/fin\/statens-pensjonsfond\/
\neksterne-rapporter-og-brev\/ags-report.pdf]].<\/p>\n

The researchers concluded that a significant proportion
\nof the fund\u2019s historical returns could be explained by
\nexposure to systematic risk factors, rather than occurring
\nas a result of active manager skill. This takes me back to
\nArnaud\u2019s point about smart beta: it\u2019s increasingly possible
\nto access these risk factors via transparent and low-cost
\nindex solutions, rather than paying extra to access them
\nvia active mandates.<\/p>\n

In another study, published in 2012 and focusing on the
\nperiod from 1990-2008[[http:\/\/papers.ssrn.com\/sol3\/papers.cfm?abstract_id=1948726]], academics Aglietta, Bri\u00e8re,
\nRigot and Signori showed that active management had
\ncontributed nothing to US pension funds\u2019 returns within
\nthe equity asset class and very little to the funds\u2019 returns
\nin fixed income.<\/p>\n

In fact, most of the equity and fixed income returns
\nearned by US pension funds came from broad market
\nexposure, something the funds could have achieved by
\nindexing. However, the researchers found that active
\nmanagement played a much more significant role than
\nmarket movements in explaining pension funds\u2019 returns in
\nhedge funds and other alternative asset classes.<\/p>\n

DEFINITIONS OF ALPHA AND BETA ARE CHANGING<\/strong><\/p>\n

[A.L.]<\/strong> I\u2019d like to expand on what Nicolas has just said.
\nAs \u201cbeta\u201d expands to encompass not just traditional,
\ncapitalisation-weighted market indices but also smart beta
\nindices, which embed different investment strategies and risk
\nfactor exposures, \u201calpha\u201d may also change its definition.<\/p>\n

There is likely to be much greater scrutiny of the extent
\nto which active managers truly add value, for example by
\nstudies focusing on managers\u2019 \u201cactive share\u201d against their
\nperformance benchmarks. And those benchmarks may be
\nmore tailored to managers\u2019 individual styles. For example, if
\nan active manager specialises in small-cap US value stocks,
\nwhy not measure his performance against the relevant smart
\nbeta index, rather than against the broad market?<\/p>\n

PASSIVES AND ALTERNATIVES ARE COMPLEMENTARY<\/strong><\/p>\n

[N.G]<\/strong> We often see passive and active management
\ndescribed as being in a fight for investors\u2019 assets. I don\u2019t
\nthink this is the right way of viewing things.
\nInstead, index-based portfolio solutions (such as passive
\nfunds and ETFs) and truly active funds (in the form
\nof alternatives) should be seen as complementary. In
\nfact, in Lyxor\u2019s view these portfolio approaches can by
\nthemselves provide a full solution for the average investor.<\/p>\n

Broad-based ETFs and other index products, typically
\ntracking capitalisation-weighted indices, are well-suited
\nto the portfolio core. They capture market risk premia and
\noffer effective diversification at low cost.<\/p>\n

ETFs are ideal for tactical asset allocation, since they offer
\nhigh granularity of exposures, ease of implementation and
\nlow execution costs. Such tactical positions could include
\nETFs based on strategy and factor indices.<\/p>\n

Alternative assets can then form the active part of the
\nportfolio, based on the principle of uncorrelated exposures
\nand unconstrained investment mandates.<\/p>\n

A typical portfolio could be split 60\/20\/20 between core
\nETFs and index products, tactical exposures using ETFs
\nand the active component, represented by alternatives.<\/p>\n

COMBINING ACTIVE AND PASSIVE<\/strong><\/p>\n

[N.G]<\/strong> Asset allocation approaches are evolving to take into
\naccount the broadening range of low-cost, index-based
\nsolutions and the growing evidence that alternatives are
\nthe true form of active management. We believe that
\ncombining traditional beta, smart beta and alternatives in
\na portfolio provides a very effective and powerful solution
\nfor the average investor.<\/p>\n

\"lyxor-smart-5.jpg\"<\/a>