Active, Passive or Enhanced?Active, Passive or Enhanced?

Sandip A. Bhagat, CFASandip A. Bhagat, CFA

Managing Director, Citigroup Asset ManagementManaging Director, Citigroup Asset ManagementPresident, Travelers Investment Management CompanyPresident, Travelers Investment Management Company

Presented atPresented at

University of ConnecticutUniversity of ConnecticutStorrs, ConnecticutStorrs, ConnecticutFebruary 20, 2004February 20, 2004

2

Discussion PointsDiscussion Points

Evolution of IndexingEvolution of Indexing

Role of Active ManagementRole of Active Management

Structured Management or Enhanced Structured Management or Enhanced Indexing as an AlternativeIndexing as an Alternative

Implementation Choices in Asset AllocationImplementation Choices in Asset Allocation

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Growth of IndexingGrowth of Indexing

$1.3 trillion in $1.3 trillion in institutional institutional indexed assetsindexed assets

Vanguard S&P Vanguard S&P 500 index fund 500 index fund has grown 8 fold has grown 8 fold in the last 5 yearsin the last 5 years

0

10

20

30

40

50

60

70

80

1990 1995 2000

$ b

illi

on

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Total Equity FixedIncome

$ tr

illi

on

4

Factors Contributing toFactors Contributing toPopularity of IndexingPopularity of Indexing

Shortfall of Active ManagementShortfall of Active Management• Imbalance between size of information advantage and Imbalance between size of information advantage and

size of active betssize of active bets

Academic Arguments of Market EfficiencyAcademic Arguments of Market Efficiency

Self-Fulfilling ProphecySelf-Fulfilling Prophecy

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Relative Merits of Passive vs. Active Relative Merits of Passive vs. Active ManagementManagement

IndexingIndexing ActiveActive ReasonReason

Relative PerformanceRelative Performance- Efficient Asset Class- Efficient Asset Class EmpiricalEmpirical

- Inefficient Asset Class- Inefficient Asset Class EvidenceEvidence

Relative CostsRelative Costs Low Info. Needs/Low Info. Needs/TurnoverTurnover

Implementing Asset AllocationImplementing Asset Allocation StyleStyleReliabilityReliability

Tax EfficiencyTax Efficiency Low TurnoverLow Turnover

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Potential Risks of IndexingPotential Risks of Indexingto the S&P 500to the S&P 500

Reversal of Size and Style EffectsReversal of Size and Style Effects

Lower Financial Asset Returns Shift Lower Financial Asset Returns Shift Focus to Active ManagementFocus to Active Management

Reversal of Self-Fulfilling ProphecyReversal of Self-Fulfilling Prophecy

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GoodGood active managers deliver consistent active managers deliver consistent value-added relative to a benchmark.value-added relative to a benchmark.

GoodGood active managers will never fall out of active managers will never fall out of favor or go out of style.favor or go out of style.

Active management should be used in Active management should be used in inefficient asset classes.inefficient asset classes.

Role of Active ManagementRole of Active Management

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Evaluating Active ManagementEvaluating Active Management

Information ratios provide the litmus test of active Information ratios provide the litmus test of active management.management.

IR = IR = = = = =

Active = Portfolio - BenchmarkActive = Portfolio - Benchmark

A high information ratio differentiates skill from A high information ratio differentiates skill from luck in active management.luck in active management.

> + 0.5> + 0.5 GoodGood< - 0.5< - 0.5 BadBad

Active ReturnActive ReturnActive RiskActive Risk

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Evaluating Active ManagementEvaluating Active Management

t-statistic =t-statistic =

IR = IR = ,, Standard Error of IR = 1/ Standard Error of IR = 1/

IR > 0.5 implies a top quartile managerIR > 0.5 implies a top quartile managerTT

EstimateEstimateStandard ErrorStandard Error

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Evaluating Active ManagementEvaluating Active Management

t - statistic of 1.6 implies a 90%t - statistic of 1.6 implies a 90%confidence levelconfidence level

0.50.5

If it can take more than 10 years to If it can take more than 10 years to confidentlyconfidently identify a identify a skilledskilled active manager, how long would it take to identify a active manager, how long would it take to identify a luckylucky or or incompetentincompetent one? one?

> 1.6 T > 10 years> 1.6 T > 10 years TT11//

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Skill and LuckSkill and Luck

BlessedBlessedInsufferableInsufferable

DoomedDoomed ForlornForlorn

Less SkillLess Skill More SkillMore Skill

More LuckMore Luck

Less LuckLess Luck

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Structured Management or Enhanced IndexingStructured Management or Enhanced IndexingAs An AlternativeAs An Alternative

Disciplined investment styleDisciplined investment style

Provides reliable asset class exposureProvides reliable asset class exposure

Adds value in a risk-controlled processAdds value in a risk-controlled process

Combines desired attributes of reliability (purely Combines desired attributes of reliability (purely passive) and value-added (purely active) into one stylepassive) and value-added (purely active) into one style

Enhances asset allocation decision through risk control Enhances asset allocation decision through risk control and value-addedand value-added

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Evolution of Asset Management Evolution of Asset Management StylesStyles

Expected Return PayoffsExpected Return PayoffsRelative to BenchmarkRelative to Benchmark

Asset Class Asset Class LessLess MoreMore ReliableReliable

ExposureExposure ReliableReliable ReliableReliable

Value Added Value Added LessLess MoreMore Reliable,Reliable,

ReliableReliable ReliableReliable but zerobut zero

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

Conventional Active Structured Purely Passive

4 to 8%4 to 8%

-4 to -8%-4 to -8%

1 to 3%1 to 3%

-1 to -3%-1 to -3%

-0.1 to -0.3%-0.1 to -0.3%

Share of EnhancedShare of Enhancedvs. All Indexingvs. All Indexing

0

5

10

15

20

25

30

1995 2000

< 5%

30%

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Expectations From Enhanced IndexingExpectations From Enhanced Indexing

Enhanced indexing represents a middle ground relative Enhanced indexing represents a middle ground relative to passive and active management in terms of active to passive and active management in terms of active risk, active returns and advisory fees.risk, active returns and advisory fees.

LargeLarge MidMid SmallSmall

Active Risk, bpsActive Risk, bps 100-200100-200 200-300200-300 300-400300-400

Active Return, bpsActive Return, bps 50-10050-100 150-180150-180 150-300150-300

Advisory Fees, bpsAdvisory Fees, bps 10-2510-25 25-5025-50 50-7050-70

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Achieve measured, focused and selective departures from index compositionAchieve measured, focused and selective departures from index composition

Conventional Strategies - Statistical Arbitrage or Research EnhancedConventional Strategies - Statistical Arbitrage or Research Enhanced

DownsideDownside Suitability forSuitability forStrategyStrategy BreadthBreadth RiskRisk Enhanced IndexingEnhanced Indexing

Stock SelectionStock Selection HighHigh LowLow (sector, size, style neutral)(sector, size, style neutral)

Industry RotationIndustry Rotation ModerateModerate ModerateModerate (sector, size, style neutral)(sector, size, style neutral)

Sector RotationSector Rotation LowerLower HighHigh

Style RotationStyle Rotation LowLow HighHigh

Size RotationSize Rotation LowLow HighHigh

Enhanced Indexing ApproachesEnhanced Indexing Approaches

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Enhanced Indexing ApproachesEnhanced Indexing Approaches

Portable Alpha Strategies (Tracking Error 1 to 3%):Portable Alpha Strategies (Tracking Error 1 to 3%):

LIBOR PlusLIBOR Plus ++ Futures Futures S&P 500S&P 500 == S&P 500 PlusS&P 500 Plus

Market NeutralMarket Neutral ++ Futures Futures S&P 500S&P 500 == S&P 500 PlusS&P 500 Plus

Long-shortLong-short

ConvertibleConvertible ++ Futures Futures S&P 500S&P 500 == S&P 500 PlusS&P 500 Plus

ArbitrageArbitrage

Mid Cap Alpha - Futures Mid Cap Alpha - Futures Mid capMid cap + Futures + Futures S&P 500S&P 500 = S&P 500 Plus = S&P 500 Plus

(Any Inefficient(Any InefficientAsset Class)Asset Class)

Derivatives arbitrage (eg. stock-index futures, rolling cheap calendar spreads) is now Derivatives arbitrage (eg. stock-index futures, rolling cheap calendar spreads) is now efficiently pricedefficiently priced

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ICIC BRBR IR = IC IR = IC ..

StockpickerStockpicker 0.050.05 200200 0.71, Excellent0.71, Excellent

Market timerMarket timer 0.120.12 22 0.18, Mediocre0.18, Mediocre

Information RatioInformation Ratio == Skill Skill .. Breadth* Breadth*

IRIR = = IC IC ..

IC = Information CoefficientIC = Information Coefficient

BR = Number of Independent Bets per YearBR = Number of Independent Bets per Year

Importance of “Breadth”Importance of “Breadth”in Active Managementin Active Management

BRBR

BRBR

*Source: Grinold & Kahn*Source: Grinold & Kahn

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SkillSkill ProbabilityProbabilityInvestment StrategyInvestment Strategy BreadthBreadth RequiredRequired of Successof Success

Diversified Active Diversified Active HighHigh LowerLower HigherHigher

Concentrated Active Concentrated Active Low/ModLow/Mod HigherHigher ModMod

Style AllocationStyle Allocation ModMod ModMod ModMod

TAA, Mkt. TimingTAA, Mkt. Timing LowLow HigherHigher LowerLower

Probability of Success Across Probability of Success Across Investment StrategiesInvestment Strategies

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Passive vs. Active:Passive vs. Active:Role of Market EfficiencyRole of Market Efficiency

Active management can be futile in Active management can be futile in efficiently priced markets (by definition).efficiently priced markets (by definition).

Markets are generally efficient in the longer Markets are generally efficient in the longer term but may provide short-term term but may provide short-term opportunities to exploit mispricing.opportunities to exploit mispricing.

Emphasize active management in inefficient Emphasize active management in inefficient asset classes.asset classes.

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Market Efficiency and Market Efficiency and Implementation ChoiceImplementation Choice

MarketMarket Recommended MixRecommended MixAsset ClassAsset Class EfficiencyEfficiency PassivePassive EnhancedEnhanced ActiveActive

(%)(%) (%)(%) (%)(%)

Large U. S. StocksLarge U. S. Stocks HighHigh 4040 3030 3030

Small U. S. StocksSmall U. S. Stocks LowLow -- 3030 7070

Core Int’l. StocksCore Int’l. Stocks ModMod 3030 3030 4040

Emerging Mkts. StocksEmerging Mkts. Stocks LowLow -- 2020 8080

U. S. BondsU. S. Bonds HighHigh 3030 4040 3030

Foreign BondsForeign Bonds ModMod 2020 3030 5050

Emerging Mkts. DebtEmerging Mkts. Debt LowLow -- 2020 8080

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SummarySummary

Various forms of indexing are likely to dominate in efficient asset Various forms of indexing are likely to dominate in efficient asset classes.classes.

Enhanced indexingEnhanced indexing

• combines reliability and value-added to enhance asset combines reliability and value-added to enhance asset allocation decisions and allocation decisions and

• may represent a cheaper outperformance call option may represent a cheaper outperformance call option

Active management can add significant value in inefficient asset Active management can add significant value in inefficient asset classes by exploiting superior information.classes by exploiting superior information.

Good active management, if you can find it, will always be in Good active management, if you can find it, will always be in demand!demand!