Structured Asset Management

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Active, Passive or Enhanced? Sandip A.
Bhagat, CFA Managing Director, Citigroup Asset
Management President, Travelers Investment
Management Company Presented at University of
Connecticut Storrs, Connecticut February 20, 2004
2
Discussion Points

• Evolution of Indexing
• Role of Active Management
• Structured Management or Enhanced Indexing as an
  Alternative
• Implementation Choices in Asset Allocation

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Growth of Indexing

• 1.3 trillion in institutional indexed assets
• Vanguard SP 500 index fund has grown 8 fold in
  the last 5 years

trillion
billion
4
Factors Contributing toPopularity of Indexing

• Shortfall of Active Management
• Imbalance between size of information advantage
  and size of active bets
• Academic Arguments of Market Efficiency
• Self-Fulfilling Prophecy

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Relative Merits of Passive vs. Active Management

• Indexing Active Reason
• Relative Performance
• - Efficient Asset Class ??? ??? Empirical
• - Inefficient Asset Class ??? ??? ?Evidence
• Relative Costs ? ? ?Low Info. Needs/
• Turnover
• Implementing Asset Allocation ? ? ?Style
• Reliability
• Tax Efficiency ? ? ?Low Turnover

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Potential Risks of Indexingto the SP 500

• Reversal of Size and Style Effects
• Lower Financial Asset Returns Shift Focus to
  Active Management
• Reversal of Self-Fulfilling Prophecy

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Role of Active Management

• Good active managers deliver consistent
  value-added relative to a benchmark.
• Good active managers will never fall out of favor
  or go out of style.
• Active management should be used in inefficient
  asset classes.

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Evaluating Active Management

• Information ratios provide the litmus test of
  active management.
• IR ? ?
• Active Portfolio - Benchmark
• A high information ratio differentiates skill
  from luck in active management.
• gt 0.5 Good
• lt - 0.5 Bad

? ?
Active Return Active Risk
?
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Evaluating Active Management

• t-statistic
• IR ???, Standard Error of IR 1/
• IR gt 0.5 implies a top quartile manager

Estimate Standard Error
T

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Evaluating Active Management
t - statistic of 1.6 implies a 90 confidence
level 0.5 If it can take more
than 10 years to confidently identify a skilled
active manager, how long would it take to
identify a lucky or incompetent one?
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Skill and Luck
More Luck
Blessed
Insufferable
Less Skill
More Skill
Doomed
Forlorn
Less Luck
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Structured Management or Enhanced IndexingAs An
Alternative

• Disciplined investment style
• Provides reliable asset class exposure
• Adds value in a risk-controlled process
• Combines desired attributes of reliability
  (purely passive) and value-added (purely active)
  into one style
• Enhances asset allocation decision through risk
  control and value-added

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Evolution of Asset Management Styles

• Expected Return Payoffs
• Relative to Benchmark

Share of Enhanced vs. All Indexing
4 to 8
30
1 to 3
-0.1 to -0.3
lt 5
-1 to -3
-4 to -8
Asset Class Less More Reliable Exposure Reliab
le Reliable Value Added Less More Reliable, R
eliable Reliable but zero
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Expectations From Enhanced Indexing

• Enhanced indexing represents a middle ground
  relative to passive and active management in
  terms of active risk, active returns and advisory
  fees.
• Large Mid Small
• Active Risk, bps 100-200 200-300 300-400
• Active Return, bps 50-100 150-180 150-300
• Advisory Fees, bps 10-25 25-50 50-70

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Enhanced Indexing Approaches

• Achieve measured, focused and selective
  departures from index composition
• Conventional Strategies - Statistical Arbitrage
  or Research Enhanced
• Downside Suitability for
• Strategy Breadth Risk Enhanced Indexing
• Stock Selection High Low ?
• (sector, size, style neutral)
• Industry Rotation Moderate Moderate ?
• (sector, size, style neutral)
• Sector Rotation Lower High ?
• Style Rotation Low High ?
• Size Rotation Low High ?

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Enhanced Indexing Approaches

• Portable Alpha Strategies (Tracking Error 1 to
  3)
• LIBOR Plus Futures SP 500 SP 500 Plus
• Market Neutral Futures SP 500 SP 500 Plus
• Long-short
• Convertible Futures SP 500 SP 500 Plus
• Arbitrage
• Mid Cap Alpha - Futures Mid cap
  Futures SP 500 SP 500 Plus
• (Any Inefficient
• Asset Class)
• Derivatives arbitrage (eg. stock-index futures,
  rolling cheap calendar spreads) is now
  efficiently priced

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Importance of Breadthin Active Management

• Information Ratio Skill . Breadth
• IR IC .
• IC Information Coefficient
• BR Number of Independent Bets per Year

Source Grinold Kahn
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Probability of Success Across Investment
Strategies

• Skill Probability
• Investment Strategy Breadth Required of Success
• Diversified Active High Lower Higher
• Concentrated Active Low/Mod Higher Mod
• Style Allocation Mod Mod Mod
• TAA, Mkt. Timing Low Higher Lower

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Passive vs. ActiveRole of Market Efficiency

• Active management can be futile in efficiently
  priced markets (by definition).
• Markets are generally efficient in the longer
  term but may provide short-term opportunities to
  exploit mispricing.
• Emphasize active management in inefficient asset
  classes.

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Market Efficiency and Implementation Choice

• Market Recommended Mix
• Asset Class Efficiency Passive Enhanced Active
• () () ()
• Large U. S. Stocks High 40 30 30
• Small U. S. Stocks Low - 30 70
• Core Intl. Stocks Mod 30 30 40
• Emerging Mkts. Stocks Low - 20 80
• U. S. Bonds High 30 40 30
• Foreign Bonds Mod 20 30 50
• Emerging Mkts. Debt Low - 20 80

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Summary

• Various forms of indexing are likely to dominate
  in efficient asset classes.
• Enhanced indexing
• combines reliability and value-added to enhance
  asset allocation decisions and
• may represent a cheaper outperformance call
  option
• Active management can add significant value in
  inefficient asset classes by exploiting superior
  information.
• Good active management, if you can find it, will
  always be in demand!