SUMMARY
- In our view, diversification in today’s complex, dynamic markets is no longer just about asset allocation and style box investing.1
- Rather, we believe client outcomes can be improved with a diversified portfolio combining active, passive and smart beta investment strategies.
- Along with a strategic allocation among these three categories, we believe clients should have a mechanism to pivot away from that allocation when appropriate.
In a recent article, “The Rise and Fall of Performance Investing,” Charles Ellis examines how the widespread adoption of indexing has allowed investors to turn their focus from price discovery to values discovery. The paper struck a nerve, creating a flurry of activity and commentary across many market participants. While the pursuant dialogue has focused on whether or not active management is dead, it’s important not to lose sight of the most meaningful point.
The most meaningful point is not whether active investing creates more value when building client portfolios. Rather, it’s the crucial role that values discovery plays in the success of these portfolios. Values discovery is the systematic process of uncovering each client’s realistic objectives that accounts for factors including wealth, income, time horizon, age, obligations, investment knowledge and personal financial history. Once these values are discovered, advisors can then architect the investment strategy that most closely aligns with each client’s values.
The framework required to build the proper investment strategy for clients needs to be adjusted as well. For many decades, the industry has tried to help clients who are accumulating assets achieve diversification through portfolio construction techniques such as asset allocation and style box investing. However, as clients’ concerns have become less focused on simply accumulating assets and more focused on their own personal values and goals, with an eye toward the decumulation stage of their investing lifecycle, the old definition of diversification is unlikely to be sufficient. Rather than asset allocation and style box investing alone, client outcomes may be improved with a diversified portfolio of active, passive and smart beta investment styles. The question is no longer which style is “better,” but rather how much of each should be used to help clients reach their goals.
The future of diversification
We’ve all been taught the merits of diversification. However, the process of properly diversifying client portfolios and continuously monitoring and adjusting allocations can be challenging. Legendary stock picker Peter Lynch coined the term “diworsification” to describe a company that expanded into businesses beyond its core competencies. The “diworsification” concept can also be applied to investors who “overdiversify” in too many investment strategies that invest in a similar manner, with similar biases. We believe that the future of diversification is going to be less about asset classes and more about investment styles and biases (Exhibit A).
To that end, we believe a properly diversified portfolio should include strategic allocations to active, passive and select smart beta strategies. Then, based on market conditions and system dynamics, clients can overweight or underweight different investment styles to help meet their needs. We all know that the mathematical theory behind diversification is sound, yet the skill and discipline required to translate theory into practice is often elusive.
The rest of this paper explores how to create robust client portfolios using a combination of active, passive and smart beta strategies. We:
- Highlight the potential benefits and considerations of each investment style.
- Provide a framework for identifying conditions for success for each.
- Discuss implementation considerations.
Active management
Active management uses a variety of factors and strategies to construct portfolios that focus on targeted market segments and seek to outperform specified benchmarks. These include, but are not limited to: valuations, earnings growth rates, momentum, credit quality, macroeconomic top-down views, risk arbitrage, options writing and asset allocation. There is increasing evidence that there are some avoidable structural costs that can improve the outcome of actively managed portfolios by implementing an alternate fund structure (Exhibit B).
Passive management
Passive investing strategies, such as index funds and passive exchange-traded funds (ETFs), employ a predetermined approach to gaining market exposure. Such strategies are designed to track the performance of an external, predesignated index and do not require forecasting or bottom-up stock selection on the part of portfolio managers (Exhibit C).
Smart beta
There is not one universally accepted definition of smart beta, also known as alternative or advanced beta. For purposes of this paper, we define it as a disciplined, rules-based strategy that focuses on adding value via portfolio construction techniques, with an emphasis on dynamic rebalancing and enhanced risk management (Exhibit D).
The importance of cycles
In our view, to achieve optimal portfolio construction, it is also important to understand where we are in a particular cycle within the complex adaptive system that is investing. Another great investor, Howard Marks, has spent a great deal of time analyzing the importance of cycles for the investment management industry. In a client letter written in 2001, Marks stated: “In the world of investing … nothing is as dependable as cycles. Fundamentals, psychology, prices and returns will rise and fall, presenting opportunities to make mistakes or to profit from the mistakes of others. Even if we can’t predict the timing and extent of cyclical fluctuations, it’s essential that we strive to ascertain where we stand in cyclical terms and act accordingly.”
We believe a thorough understanding of the positives and negatives of the different investment styles, combined with an assessment of the current environment in context of a particular cycle, will enhance the likelihood of meeting or exceeding client expectations. We further believe that having a strategic balance of all three investment styles is the first step in the process, followed by creating a mechanism to pivot away from the strategic allocation when appropriate.
Complex adaptive systems
There have been too many debates to count regarding market efficiency. The decision to award the Nobel Prize to both Eugena Fama, an early pioneer of the efficient market hypothesis, as well as Robert Shiller, a strong critic of the hypothesis, is a pretty good sign that the debate will continue for some time.
There is another element of the conversation focused on a relatively newly articulated phenomenon that treats the markets as a complex adaptive system. This requires us to consider how we address the fact that investors often make judgments with incomplete information or by overrelying on varying decision rules. Researchers have been studying sciences ranging from physics to biology to economics to better understand how the complex adaptive system theory can help us make better decisions and deliver better client outcomes.
Michael Mauboussin of Credit Suisse has spent a great deal of time on this topic and published a paper in the Journal of Applied Corporate Finance that highlights some of the essential properties gathered from the multidisciplinary research of complex adaptive systems. Many of these properties can assist in portfolio construction and diversification efforts.
According to Mauboussin, the essential properties of a complex adaptive system are:
- Aggregation: Aggregation refers to the emergence of complex, large-scale behaviors from the collective interactions of many individual agents.
- Adaptive decision rules: Agents within complex adaptive systems take information from the environment and combine it with their own interactions with the environment to derive decision rules. This process allows for adaptation.
- Nonlinearity: The aggregation of the information provided by individual participants is more complex than by totaling the individual parts.
- Feedback loops: The feedback system is when the output of one iteration of activity becomes the input for the next iteration, which can often amplify or dampen a particular effect.
As we try to increase the probability of success when creating client-focused solutions, it is helpful to consider the research conducted outside of the capital markets and build an awareness of complex adaptive systems into the process. If we can combine the lessons learned from studying sciences such as physics and biology with the lessons learned from capital markets, we can begin the process of meeting client-specific objectives. The remaining steps would then be developing an understanding of client objectives, along with a framework for combining diversifying strategies to increase the odds of long-term success.
Cycle awareness
Past performance is no guarantee of future results. What feels like the most overused disclosure in our industry is a powerful reminder that the current environment – whatever that environment might be – is only temporary. Performance cycles and reversion to the mean are two of the most consistent phenomenon in investing. However, they are also two of the least understood. They can also be two of the biggest drivers of client disappointment in the performance of their portfolios.
Exhibit E shows the relative rankings of the large-cap indexes in a peer group of active managers on a rolling five-year basis. Currently, all three of the large-cap indexes would rank in the top 20% of active managers for five-year return if you could invest directly in an index, which of course you cannot. There are a number of ways to interpret this data. One of the more popular responses seen in the market today is to simply extrapolate the last five years into the future and pronounce the death of active management.
Another plausible reaction could be to consider what many call the “outside view.” Using the outside view, we can acknowledge the possibility that we are at a point in the cycle where reversion to the mean might set in going forward. We could also look back in history and see what has happened in similar instances. In times when the benchmark has been in the top quartile of its category rankings, the relative performance of passive investing in the subsequent five-year period has been in the fourth, third and second quartiles for large-growth, large-core and large-value asset classes, respectively. Rather than seeing a problem as unique, the outside view asks if there are similar situations that can provide a statistical basis for making a decision and, if so, what happened to other investors who faced comparable problems. The outside view may be an unnatural way to think, but it allows for a more robust context when making decisions in probabilistic scenarios.
Market dynamics
There are some key market dynamics that can also assist in the decision to increase or decrease one’s exposure to active management. We looked at a number of factors that have been shown to be indicative of markets in which active management should perform well. The factors studied included, but were not limited to:
- The level of interest rates.
- Market direction.
- Volatility levels, as measured by the Chicago Board Options Exchange Market Volatility Index (VIX).
- A breakdown of returns between market, sector-industry and company.
- The correlation among securities over 63-, 126- and 252-day periods.
- The cross-sectional volatility of the market.
In general, we found that most of these factors provide more “noise” than meaningful signal. Other factors were strong indicators of potential active management success, but were more secular in nature. The secular factors that tend to benefit active management are rising interest-rate environments as well as down markets for equity indexes. However, the goal of our study was to identify cyclical trends that we can study to increase one’s chances of success when implementing not only active, but also passive and smart beta strategies, in client portfolios.
VIX levels
Specifically, when the three-year average of the VIX is either above 21 or below 16, active management has historically tended to outperform passive management (Exhibit F). We studied three-year averages in order to better understand long-term trends. While there are often short-term spikes in volatility, it is important to note that a longer-term trend of heightened volatility is generally the best scenario in which to evaluate the performance of actively managed portfolios.
An interesting takeaway from the analysis is that different market regimes have varying impacts on style investing. For example, active management in the growth category performs best when VIX levels are below 16 for three-year periods, while value and core active management does best when VIX levels are above 21.
Cross-sectional volatility
In addition to volatility, our analysis suggests that cross-sectional volatility is yet another market dynamic that can assist in increasing the likelihood of success with active management. Cross-sectional volatility can be regarded as an efficient estimator of the average idiosyncratic volatility of stocks within the universe under consideration. For example, when using the S&P 500 Index as the universe, our analysis indicates that active management is most successful when the cross-sectional volatility is above 12.5 over a three-year period (Exhibit G). The analysis of this particular market dynamic is consistent across styles.
Correlation
The final market dynamic that can provide some insight in helping to decipher active management trends is the correlation of one-day returns for the stock market. The most common time horizons for studying correlation are 63 days, 126 days and 252 days. Our analysis suggests that the 252-day rolling correlation provides the most reliable signal for active management trends (Exhibit H).
Similar to the VIX level analysis, there are different impacts, depending on the investment style being studied. However, unlike the VIX analysis, there is one common level used in this analysis. What we have found is that when the correlation of one-day returns is greater than 0.55, active management within the growth category benefits. However, when the correlation is below 0.55, active management benefits in the value and core categories.
Putting it all together
While there is no “smoking gun” to identify when either active or passive strategies are likely to be most attractive, we can monitor market conditions and create a dashboard to adjust away from a strategic allocation among active, passive and smart beta strategies. When combining the current market-level data with an anticipated change in the interest-rate cycle, the framework suggests a slight overweight allocation to active and smart beta strategies at the expense of passive investments. Based on this analysis, the highest probability of active management success currently appears to lie within the growth segments of the market, which is where it is generally recommended that many investors take the majority of their active management risk.
Perhaps your clients need more passive investing vehicles in their portfolios, or perhaps introducing smart beta strategies into those portfolios is the best option. What the next steps are for you and your clients should depend on the current makeup of their existing portfolios, among other considerations. However, for many clients, we believe that transitioning to a more diversified portfolio containing active, passive and smart beta investment options can deliver robust, resilient strategies to meet each client’s unique objectives.
1Diversification does not guarantee profit or eliminate the risk of loss.
About Eaton Vance
Eaton Vance Corp. is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors.
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