MSCI: Bridging the Gap
Posted: 1 June 2017 | Source: MSCI
Asset owners enjoy a growing array of choices in implementing equity factor allocations. In addition to traditional passive and active mandates, single factor, and more recently, multi-factor investment strategies are used increasingly by long-term institutional investors aiming to enhance returns or manage volatility.
Asset owners face a challenge in determining how the factor allocation fits into the overall equity program: How does the factor allocation relate to the existing roster of active managers? This paper uses a risk budgeting framework to investigate how active mandates and factor allocations can be combined. Risk budgeting connects the manager selection process with the factor allocation process, without requiring expected return assumptions.
Key questions: 1) how does the level of active risk in active management affect the factor allocation decision, 2) what share of the portfolio can be deployed to the factor allocation and 3) what are the implications of a top-down versus a bottom-up factor allocation?
Active managers with relatively high levels of tracking error may have factor exposures that affect the appropriate factor allocation. Asset owners whose managers have a preference for smaller-capitalized, more volatile, value stocks may be able to diversify these exposures by allocating to factors such as low volatility, quality or momentum.
Asset owners who wish to maintain their existing roster of active managers and incorporate factor views may consider a top-down factor implementation, funded entirely from the core passive allocation. This approach distributed most of the active risk to active managers. The factor allocation preserved active managers’ specific views and diversified systematic risk.
Asset owners who wish to preserve their existing roster of active managers and incorporate high-conviction factor views may consider an allocation between active management and a bottom-up factor implementation. This approach more evenly distributed the risk budget to active management and the factor allocation. The factor allocation was partially funded from active management in this scenario.
Lastly, asset owners who pursue a “barbell” strategy between core passive allocations and concentrated active managers could implement a low volatility factor allocation. This allocation may lower the total risk of the equity program, releasing active risk budget that can be deployed to active managers. In our analysis, allocating 20% of capital to a low volatility mandate reduced total volatility in the equity program by almost 10%. Alternatively, the allocation to active management could have been increased to over 50% from 30%, while maintaining the same level of total volatility.