Combining active and index strategies to achieve a desired outcome

April 24, 2018

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Institutional investors typically pursue one of four investment objectives: long-term growth, absolute return, liability-driven investment (LDI), or principal protection.

To achieve any of these or other goals, it's critical to think about not just the components of an investment lineup or portfolio but how they work together. Such is the case with active and index strategies. Although often perceived as an "either/or" choice, these strategies can be used together to help meet a desired outcome—whether you are overseeing a defined contribution (DC) plan, a defined benefit (DB) plan, or nonprofit.

Encouraging diversified portfolios

With regard to DC retirement plans, when you have a participant demographic that strongly believes in active management, a goal can be to encourage those participants to strike a balance between low-cost, broad-based active and index strategies.

The reason is that to be successful at active management, it's widely accepted that you must be able to identify talent at a low cost—a tall order. However, often overlooked is that success also depends on an investor's ability to stick with active managers through periods of underperformance as well as outperformance.

Indexing narrows the range of possible underperformance, potentially making it easier for participants who may be drawn to active management to stick with their strategy when times get tough. The cost is surrendering the potential for outperformance, but it may be a cost worth paying.

Consider an all-active portfolio. The risk when using active funds exclusively is that in volatile markets and uncertain times, underperformance can lead to an elevated risk of investors bailing on an agreed-upon investment strategy. Studies have shown that this kind of investor behavior is counterproductive.

But by narrowing outcomes, indexing can help by truncating the risk of unwise investor behavior as well as better meet sponsors' and participants' performance expectations. To a lesser degree, using actively managed, multimanager funds can also narrow outcomes. However, adding a slice of passively managed funds can also help to lower the overall cost of the offering.

Adding index funds to a portfolio can shrink performance distribution around the market, reducing flight risk: A theoretical example

portfolio's periodic returns

Source: Vanguard.

Plan sponsors can champion this low-cost, risk-controlled approach with plan design, leading participants to construct broadly diversified portfolios with an index core.

For example, sponsors can select for the plan's qualified default investment alternative (QDIA), a low-cost, index-based target-date fund (TDF). They can also implement regular investment reenrollments, moving participants who may not hold an age-appropriate allocation into an age-appropriate investment such as a TDF.

Additionally, sponsors can offer a curated list of broadly diversified, low-cost active U.S. equity funds, international equity funds, and fixed income funds in addition to TDF and index fund options.

Of course, with any active approach, it is important to have conviction in the manager‘s ability to add value. This requires that a committee spend time understanding the approach. Vanguard Defined Contribution Advisory Services (DCAS) works with Vanguard Portfolio Review Department to help committees with this, particularly for Vanguard's active funds.

What of traditional institutional investors—DB pension plans and nonprofits?

Similar to DC plans and their participants, DB pension plan sponsors and nonprofit organizations should start with their portfolio objective. Careful consideration of both active and passive strategies and how they may align to the portfolio objectives are of utmost importance.

Let's consider some examples:

Aligning holdings with pension liability

As DB pension plan sponsors try to find the optimal trade-off between risk and return in their pension portfolios, many are "derisking." This involves moving assets, as funding status improves, from riskier, return-generating holdings into longer-duration fixed income holdings that better align with the pension liability. Deciding between active and passive fixed income exposures is secondary relative to the need to match liabilities.

Vanguard Institutional Advisory Services® (VIAS™) can evaluate the characteristics of a pension plan's cash flows and duration profile to identify the mixture of fixed income funds that gives the best match to duration and credit risk/spread exposure over time. In some cases, that may be all active, in others all passive, and in some cases, it might be a mixture of active and passive.

Stretching for total return

Nonprofits with long (or infinite) time horizons, uncertainty around fundraising, and rising payout pressures may opt to take on greater risk through more aggressive portfolio strategies. While many have focused on higher-cost alternative strategies, we believe a better way for nonprofits to put more money toward their mission is to focus on what they can control, such as costs. And while indexing has, to many, become synonymous with low cost, the historical data actually shows a more nuanced reality—low cost and, therefore, improved odds of investor success—can exist in both active and indexed funds.1

In cases where increased expected returns are required, VIAS can help a nonprofit assess the trade-offs between pursuing alpha and increasing the exposure to equities through changes to a portfolio's asset allocation.

VIAS estimates the impact of asset allocation changes using the Vanguard Capital Markets Model® (VCMM), focusing on key metrics such as expected returns, expected volatility, downside risk, and the probability of meeting a required (or desired) return. When a desire, or need, for alpha exists, VIAS combines the output from the VCMM with an analysis focusing on expected impact to a portfolio's tracking error relative to the alpha needs of various active strategies.

Final thoughts

The bottom line is that we believe you can combine low-cost active and index strategies to achieve various objectives. However, with uncertainty an inherent part of the markets, we suggest being strategic in areas that you can control.

Combine aspects from active management (gross alpha, cost, active risk) and an understanding of your goals to strike the right balance between active and index strategies. Being methodical allows you to customize with confidence, with better outcomes for all.

1 Wallick, Daniel W., Brian R. Wimmer, Christos Tasopoulos, James Balsamo, and Joshua M. Hirt, 2017. Making the implicit explicit: A framework for the active-passive decision. Valley Forge, Pa.: The Vanguard Group.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss.
  • Past performance is no guarantee of future results.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target-date funds is not guaranteed at any time, including on or after the target date.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.
  • IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model®(VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
  • The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
  • The Vanguard Capital Markets Models® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
  • Advice services offered through Vanguard Institutional Advisory Services are provided by Vanguard Advisers, Inc., a registered investment advisor.