IMPLEMENTATION CHOICES

Learning Outcome

• discuss strategic implementation choices in asset allocation, including passive/active choices and vehicles for implementing passive and active mandates

Having established the strategic asset allocation policy, the asset owner must address additional strategic considerations before moving to implementation. One of these is the passive/active choice.

There are two dimensions of passive/active choices. One dimension relates to the management of the strategic asset allocation itself—for example, whether to deviate from it tactically or not. The second dimension relates to passive and active implementation choices in investing the allocation to a given asset class. Each of these are covered in the sections that follow.

In an advisory role, asset managers have an unequivocal responsibility to make implementation and asset selection choices that are initially, and on an ongoing basis, suitable for the client.29

Passive/Active Management of Asset Class Weights

Tactical asset allocation (TAA) involves deliberate short-term deviations from the strategic asset allocation. Whereas the strategic asset allocation incorporates an investor’s long-term, equilibrium market expectations, tactical asset allocation involves short-term tilts away from the strategic asset mix that reflect short-term views—for example, to exploit perceived deviations from equilibrium.

Tactical asset allocation is active management at the asset class level because it involves intentional deviations from the strategic asset mix to exploit perceived opportunities in capital markets to improve the portfolio’s risk–return trade-off. TAA mandates are often specified to keep deviations from the strategic asset allocation within rebalancing ranges or within risk budgets. Tactical asset allocation decisions might be responsive to price momentum, perceived asset class valuation, or the particular stage of the business cycle. A strategy incorporating deviations from the strategic asset allocation that are motivated by longer-term valuation signals or economic views is sometimes distinguished as dynamic asset allocation (DAA).

Tactical asset allocation may be limited to tactical changes in domestic stock–bond or stock–bond–cash allocations or may be a more comprehensive multi-asset approach, as in a global tactical asset allocation (GTAA) model. Tactical asset allocation inherently involves market timing as it involves buying and selling in anticipation of short-term changes in market direction; however, TAA usually involves smaller allocation tilts than an invested-or-not-invested market timing strategy.

Tactical asset allocation is a source of risk when calibrated against the strategic asset mix. An informed approach to tactical asset allocation recognizes the trade-off of any potential outperformance against this tracking error. Key barriers to successful tactical asset allocation are monitoring and trading costs. For some investors, higher short-term capital gains taxes will prove a significant obstacle because taxes are an additional trading cost. A program of tactical asset allocation must be evaluated through a cost–benefit lens. The relevant cost comparisons include the expected costs of simply following a rebalancing policy (without deliberate tactical deviations).

Passive/Active Management of Allocations to Asset Classes

In addition to active and passive decisions about the asset class mix, there are active and passive decisions about how to implement the individual allocations within asset classes. An allocation can be managed passively or actively or incorporate both active and passive sub-allocations. For investors who delegate asset management to external firms, these decisions would come under the heading of manager structure,30 which includes decisions about how capital and active risk are allocated to points on the passive/active spectrum and to individual external managers selected to manage the investor’s assets.31

With a passive management approach, portfolio composition does not react to changes in the investor’s capital market expectations or to information on or insights into individual investments. (The word passive means not reacting.) For example, a portfolio constructed to track the returns of an index of European equities might add or drop a holding in response to a change in the index composition but not in response to changes in the manager’s expectations concerning the security’s investment value; the market’s expectations reflected in market values and index weights are taken as is. Indexing is a common passive approach to investing. (Another example would be buying and holding a fixed portfolio of bonds to maturity.)

In contrast, a portfolio manager for an active management strategy will respond to changing capital market expectations or to investment insights resulting in changes to portfolio composition. The objective of active management is to achieve, after expenses, positive excess risk-adjusted returns relative to a passive benchmark.

The range of implementation choices can be practically viewed as falling along a passive/active spectrum because some strategies use both passive and active elements. In financial theory, the pure model of a passive approach is indexing to a broad market-cap-weighted index of risky assets—in particular, the global market portfolio. This portfolio sums all investments in index components and is macro-consistent in the sense that all investors could hold it, and it is furthermore self-rebalancing to the extent it is based on market-value-weighted indices. A buy-and-hold investment as a proxy for the global market portfolio would represent a theoretical endpoint on the passive/active spectrum. However, consider an investor who indexes an equity allocation to a broad-based value equity style index. The investment could be said to reflect an active decision in tilting an allocation toward value but be passive in implementation because it involves indexing. An even more active approach would be investing the equity allocation with managers who have a value investing approach and attempt to enhance returns through security selection. Those managers would show positive tracking risk relative to the value index in general. Unconstrained active investment would be one that is “go anywhere” or not managed with consideration of any traditional asset class benchmark (i.e., “benchmark agnostic”). The degree of active management has traditionally been quantified by tracking risk and, from a different perspective, by active share.

Indexing is generally the lowest-cost approach to investing. Indexing involves some level of transaction costs because, as securities move in and out of the index, the portfolio holdings must adjust to remain in alignment with the index. Although indexing to a market-cap-weighted index is self-rebalancing, tracking an index based on other weighting schemes requires ongoing transactions to ensure the portfolio remains in alignment with index weights. An example is tracking an equally weighted index: As changes in market prices affect the relative weights of securities in the portfolio over time, the portfolio will need to be rebalanced to restore equal weights. Portfolios tracking fixed-income indices also incur ongoing transaction costs as holdings mature, default, or are called away by their issuers.

Exhibit 13 diagrams the passive/active choice as a continuum rather than binary (0 or 1) characteristic. Tracking risk and active share are widely known quantitative measures of the degree of active management that capture different aspects of it. Each measure is shown as tending to increase from left to right on the spectrum; however, they do not increase (or decrease) in lockstep with each other, in general.

Exhibit 13:

Passive/Active Spectrum

Asset class allocations may be managed with different approaches on the spectrum. For example, developed market equities might be implemented purely passively, whereas emerging market bonds might be invested with an unconstrained, index-agnostic approach.

Factors that influence asset owners’ decisions on where to invest on the passive/active spectrum include the following:

• Available investments. For example, the availability of an investable and representative index as the basis for indexing.

• Scalability of active strategies being considered. The prospective value added by an active strategy may begin to decline at some level of invested assets. In addition, participation in it may not be available below some asset level, a consideration for small investors.

• The feasibility of investing passively while incorporating client-specific constraints. For example, an investor’s particular ESG investing criteria may not align with existing index products.

• Beliefs concerning market informational efficiency. A strong belief in market efficiency for the asset class(es) under consideration would orient the investor away from active management.

• The trade-off of expected incremental benefits relative to incremental costs and risks of active choices. Costs of active management include investment management costs, trading costs, and turnover-induced taxes; such costs would have to be judged relative to the lower costs of index alternatives, which vary by asset class.

• Tax status. Holding other variables constant, taxable investors would tend to have higher hurdles to profitable active management than tax-exempt investors.32 For taxable investors who want to hold both passive and active investments, active investments would be held, in general, in available tax-advantaged accounts.

The curriculum readings on equity, fixed-income, and alternative investments will explore many strategies and the nature of any active decisions involved. Investors do need to understand the nature of the active decisions involved in implementing their strategic asset allocations and their appropriateness given the factors described. Exhibit 14 shows qualitatively (rather than precisely) some choices that investors may consider for equity and fixed-income allocations. In the exhibit, non-cap-weighted indexing includes such approaches as equal weighting and quantitative rules-based indexing approaches (discussed further in the equity readings).33

Exhibit 14:

Placement on the Passive/Active Spectrum: Examples of Possible Choices

EXAMPLE 8

Implementation Choices (1)

1. Describe two kinds of passive/active choices faced by investors related to asset allocation.

   Solution to 1:

   One choice relates to whether to allow active deviations from the strategic asset allocation. Tactical asset allocation and dynamic asset allocation are examples of active management of asset allocations. A second set of choices relates to where to invest allocations to asset classes along the passive/active spectrum.

2. An equity index is described as “a rules-based, transparent index designed to provide investors with an efficient way to gain exposure to large-cap and small-cap stocks with low total return variability.” Compared with the market-cap weighting of the parent index (with the same component securities), the weights in the low-volatility index are proportional to the inverse of return volatility, so that the highest-volatility security receives the lowest weight. Describe the active and passive aspects of a decision to invest an allocation to equities in ETFs tracking such indices.

   Solution to 2:

   The active element is the decision, relative to the parent index, to overweight securities with low volatility and underweight securities with high volatility. This management of risk is distinct from reducing portfolio volatility by combining a market-cap-weighted index with a risk-free asset proxy because it implies a belief in some risk–return advantage to favoring low-volatility equities on an individual security basis. The passive element is a transparent rules-based implementation of the weighting scheme based on inverse volatilities.

3. Describe how investing in a GDP-weighted global bond index involves both active and passive choices.

   Solution to 3:

   The passive choice is represented by the overall selection of the universe of global bonds; however, the active choice is represented by the weighting scheme, which is to use GDP rather than capital market weights. This is a tilt toward the real economy and away from fixed-income market values.

EXAMPLE 9

Implementation Choices (2)

Describe characteristic(s) of each of the following investors that are likely to influence the decision to invest passively or actively.

1. Caflandia sovereign wealth fund

   For a large investor like the Caflandia sovereign wealth fund (CAF$40 billion), the scalability of active strategies that it may wish to employ may be a consideration. If only a small percentage of portfolio assets can be invested effectively in an active strategy, for example, the potential value added for the overall portfolio may not justify the inherent costs and management time. Although the equities and fixed-income allocations could be invested using passive approaches, investments in the diversifying strategies category are commonly active.

2. GPLE corporate pension

   The executives responsible for the GPLE corporate pension also have other, non-investment responsibilities. This is a factor favoring a more passive approach; however, choosing an outsourced chief investment officer or delegated fiduciary consultant to manage active manager selection could facilitate greater use of active investment.

3. The Lee family

   The fact that the Lees are taxable investors is a factor generally in favor of passive management for assets not held in tax-advantaged accounts. Active management involves turnover, which gives rise to taxes.

4. Auldberg University Endowment

   According to the vignette in Example 3, the Auldberg University Endowment has substantial staff resources in equities, fixed income, and real estate. This fact suggests that passive/active decisions are relatively unconstrained by internal resources. By itself, it does not favor passive or active, but it is a factor that allows active choices to be given full consideration.

Risk Budgeting Perspectives in Asset Allocation and Implementation

Risk budgeting addresses the questions of which types of risks to take and how much of each to take. Risk budgeting provides another view of asset allocation—through a risk lens. Depending on the focus, the risk may be quantified in various ways. For example, a concern for volatility can be quantified as variance or standard deviation of returns, and a concern for tail risk can be quantified as VaR or drawdown. Risk budgets (budgets for risk taking) can be stated in absolute or in relative terms and in money or percent terms. For example, it is possible to state an overall risk budget for a portfolio in terms of volatility of returns, which would be an example of an absolute risk budget stated in percent terms (for example, 20% for portfolio return volatility). Risk budgeting is a tool that may be useful in a variety of contexts and asset allocation approaches.

Some investors may approach asset allocation with an exclusive focus on risk. A risk budgeting approach to asset allocation has been defined as an approach in which the investor specifies how risk (quantified by some measure, such as volatility) is to be distributed across assets in the portfolio, without consideration of the assets’ expected returns.34 An example is aiming for equal expected risk contributions to overall portfolio volatility from all included asset classes as an approach to diversification, which is a risk parity (or equal risk contribution) approach. A subsequent reading in asset allocation addresses this in greater detail.

More directly related to the choice of passive/active implementation are active risk budgets and active risk budgeting. Active risk budgeting addresses the question of how much benchmark-relative risk an investor is willing to take in seeking to outperform a benchmark. This approach is risk budgeting stated in benchmark-relative terms. In parallel to the two dimensions of the passive/active decision outlined previously are two levels of active risk budgeting, which can be distinguished as follows:

• At the level of the overall asset allocation, active risk can be defined relative to the strategic asset allocation benchmark. This benchmark may be the strategic asset allocation weights applied to specified (often, broad-based market-cap-weighted) indices.

• At the level of individual asset classes, active risk can be defined relative to the asset class benchmark.

Active risk budgeting at the level of overall asset allocation would be relevant to tactical asset allocation. Active risk budgeting at the level of each asset class is relevant to how the allocation to those asset classes is invested. For example, it can take the form of expected-alpha versus tracking-error optimization in a manner similar to classic mean–variance optimization. If investment factor risks are the investor’s focus, risk budgeting can be adapted to have a focus on allocating factor risk exposures instead. Later readings revisit risk budgeting in investing in further detail.