Diversification: Active Vs. Passive Management

Dec.15.11 | About: SPDR S&P (SPY)

In our work and research related to portfolio optimization, asset allocation and quantitative investment strategies, we use historical data and seek to maximize “forward information.” Our goal is to improve risk-adjusted returns and achieve prudent diversification.

In a recent article on Managed Futures and Commodities, we reviewed the performance of several asset classes during 2011 (through the end of November). Some investors noticed that the actual performance of some key asset classes outperformed professionally-managed funds. For instance, the S&P 500 is actually positive (+1%) as of the end of November, beating many actively-managed funds. In addition, because the S&P 500 was positive – along with government bonds (intermediate-term government bonds are +8% through November) – some investors are surprised to see Global Macro approaches down for the year.

Active versus Passive Management

Based on the performance of the S&P 500 and government bonds so far in 2011, we can see that a simple 60% stock / 40% bond mix would have eked out a small, but positive return, through the end of November. Why, then, are Global Macro, as well as many stock funds – and so many hedge fund categories, down for the year?

Professional portfolio managers are paid to manage risk. In the case of the stock market, we have seen very large swings – and money managers need to protect their clients and portfolios from large declines. In 2011 alone, the S&P 500 had at least five declines of 100 S&P points, or relatively large declines of about -7.5%. These declines took place in March, May, August, October and November. The August decline totaled about 200 S&P points, or about a -15% decline.

In each of these cases, many active managers might have reduced their equity exposure for fear of the large -40% declines investors witnessed in 2008 and 2000-2002. However, the S&P rallied each of these times in 2011 and is currently close to unchanged for the year.

S&P 500 (2011, through November 30)

S&P 500 (2011, through November 30)

During 2011, the S&P 500 has stayed mainly in the 1150 to 1350 range and is currently trading near the 1220 level. Passive vehicles are good proxies for the underlying asset class. For instance, the S&P 500, as measured by the SPY, is flat for the year through the end of November. Bonds, as measured by the Vanguard Intermediate-Term Treasuries (MUTF:VFITX) fund, are up about +8% through the end of November.

Many portfolio managers who actively manage risk are underperforming the S&P 500 because they reduced their equity exposure just before the reversals. In a similar manner, many active bond managers did not believe that interest rates could fall further and thus had less than full fixed income exposure, as compared to their benchmarks. Thus, a large percentage of bond managers are underperforming their benchmarks as well.

The Active versus Passive Choice

Diversified portfolios typically include investments in asset classes such as stocks and bonds and sometimes alternative investment strategies such as commodities, hedge funds, and managed futures.

However, the decision to invest in active strategies and/or passive approaches within these asset classes should be a conscious decision that investors choose. As with many choices, there are pros and cons.

Passive Investment Characteristics

  • You get what you see. That is, the passive investment performance will be highly correlated to the performance of the underlying asset class.

  • Typically lower fees than actively managed strategies.

  • Passive approaches are typically more tax-efficient because there is less turnover, thus triggering fewer tax events.

  • Potentially higher risk due to passive strategy of sticking with the asset class, even through large declines. On the other hand, passive strategies have outperformed many active managers in 2011.

Active Management Characteristics

  • Actively managed strategies focus on performance related to risk and downside losses.

  • Less downside, but sometimes less upside.

  • Normally correlated to underlying asset class, but lower correlations to underlying assets than passive investments (due to active management).

  • In the long-term, active management should offer better risk-adjusted performance.

Diversification

Based on these observations, many investors will see that there is a place in a well-diversified portfolio for both active and passive approaches. Very large institutional investors such as billion-dollar endowments and public funds sometimes prefer passive approaches so they do not have to worry (quite as much) about market impact, liquidity, and commissions.

However, large institutional investors often decide to allocate portions of their funds to both active and passive management. This will increase diversification – and over the long-term, should help with downside risk and risk-adjusted performance. Individual investors may also decide to allocate to both active and passive approaches.

The Active/Passive Decision & Key Takeaways from 2011

Although passive strategies outperformed active strategies in the stock and bond markets in 2011, this is not always the case. We should remember that more active approaches are designed to manage risk more proactively.

For instance, during the poor years of stock performance from 2000-2002, and 2008 (when the stock market lost about -40% and -37%, respectively), many actively managed hedge funds and their investors did not suffer the same declines. What can institutional, as well as individual, investors learn from these observations, data, and historical performance?

  • There is definitely a place for passive investments alongside more active approaches.

  • Passive strategies may offer higher correlations to the underlying asset class (versus active strategies). Portfolio managers may want to keep this in mind if the fund’s objective is diversification relative to a specific asset class.

  • Active approaches will not be right all of the time, as we saw in 2011.

  • Active approaches can help control risk and drawdowns.

  • Using both passive and active approaches should increase overall diversification and will increase a portfolio’s overall risk-return characteristics.

  • After a difficult 2011, it will be interesting to see if professional fund managers can earn their keep in 2012. Based on 2011, this is true in markets ranging from stocks, bonds, commodities, and managed futures.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.