Passive investing is popular—but it isn’t risk free. By combining active and passive approaches in an equity allocation, we think investors can effectively reduce risk relative to a single manager and also enjoy better returns than those of the benchmark.
The belief that passive investing is risk free is a misconception, in our view. While passive portfolios may address concerns about relative risk, they won’t help an investor mitigate absolute risk when markets decline. Passive portfolios may also leave investors exposed to market bubbles and distortions. And by choosing a purely passive approach, an investor will forgo any potential for additional returns when it matters most—in an era of market performance that is likely to be subdued.
Creating High-Conviction Combinations
In recent years, heavy fund flows into passive portfolios have reflected the growing belief that active managers cannot reliably outperform. While it’s true that even skilled active managers will not outperform every year, many have demonstrated an ability to do so over time.
Our research identified US large-cap equity managers who demonstrated conviction in various ways. We then looked at how combinations of these high-conviction equity managers performed in an equity allocation. We found that there are many different ways to reduce risk.
The three examples below demonstrate different approaches to achieving the same amount of relative risk. In the first two cases, we found that risk could be reduced to similar levels—from about 6% tracking error to 3%—by combining five concentrated equity managers or by putting together a package of three different types of high-conviction managers with diverse characteristics (Display).
The third case (right-hand side of above display) shows that combining passive and active portfolios can be effective, too. By combining passive and high-conviction portfolios with diversifying characteristics, we found, investors can reduce tracking error substantially compared to the purely active single-manager option, while also enjoying better returns than the benchmark provides, before fees (Display).
Different types of investing strategies require different mixes of passive and active allocations to reduce risk effectively For example, creating a growth allocation that is 55% passive and 45% active would cut tracking error by more than half, to 3%, from 6.6% for a 100%-active growth strategy, while still delivering above-benchmark returns. In a dividend-yield approach, it would take 22% passive allocation to achieve a similar result. By contrast, an all-active mix with a growth-oriented combination could create an allocation with a similar risk profile but higher returns.
Fee Budgets Matter
Of course, there are many things to consider before choosing the right approach for individual needs. For example, fee budgets may determine how much is available to allocate to active strategies. Yet there is a trade-off between the additional cost of fees for skilled high-conviction active managers and the risk reduction achieved in cheaper, passive portfolios. As the display shows, the all-active combination delivered an annualized relative return of 1.6—about twice the return of the active growth and passive combination. In other words, the all-active combination delivered an 81-basis-point advantage, which should be compared to the incremental fees of having a 55% greater allocation to active managers.
Additional considerations include an investor’s philosophy about different approaches to the markets. Manager-selection risk adds further uncertainty. If you can identify an active manager who is capable of consistently beating the benchmark after fees, then we believe it’s preferable to stay active and forgo passive strategies. But armed with an understanding of how passive and active approaches work together, investors can address the many considerations related to manager selection with the right mix of strategies.
To make an equity allocation work harder, the portfolios that you pick matter. Much depends on how much active risk you can tolerate. We believe that combining different high-conviction strategies—or combining active and passive strategies—can help investors ensure that money spent on active management is deployed appropriately for their individual goals.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.