Active vs. Passive SAA

Jason Baran, Insight Analyst (Investments)

A review of SAA

A Strategic Asset Allocation (SAA) sets the weight of each asset class in a portfolio over the long-term so that it can meet its return objectives and abide by its risk constraints. The use of SAA, and diversifying across several assets to reduce total risk, was first described in the 1950s by Harry Markowitz as part of Modern Portfolio Theory. By using a selection of assets, and relying on these assets being uncorrelated, we can reduce the total risk of the portfolio as measured against the total individual risks of these assets.

While there have been some challenges to the theory, its use has become wide spread thanks to its relative simplicity and intuitive understanding of its concepts – everyone knows to not place all your eggs in one basket! 

The active vs. passive debate 

We frequently hear of ‘active vs. passive’ in terms of index tracking funds against their actively managed fund counterparts. For example, what are the merits of an active UK equity manager who risks either outperforming or making a loss, against a tracker fund which will track the benchmark index, but underperform by a certain handful of basis-points.

Less frequently mentioned, but along similar lines, there are multi asset funds using both active and passive strategies at an asset allocation level. Instead of tracking the more commonly known single asset indexes, such as the FTSE100 or S&P500, they will typically track a multi asset composite containing a mix of equities, government and corporate bonds, property and possibly some alternatives.

Apples and Oranges

The lack of a standard global multi asset benchmark can make the comparison of fund performances difficult. One way is to segment the multi asset funds available by risk level classification and measure performance at each level individually. Funds at the same risk level may employ different SAAs across different assets, but will aim to deliver a similar risk and return for the investor – in theory!

Risk adjusted returns are a good start. However, multi asset funds can contain several underlying fund holdings that require further digging. This is especially important as over recent years, many multi asset funds have moved into more ‘alternative’ asset classes in order to generate higher returns and diversify. This can include assets such as private equity, infrastructure, hedge funds, commodities and so on. Again, this is good in theory but these asset classes will be unfamiliar to many investors and require extra scrutiny. It is particularly important that investors understand how returns are generated and their associated risks. For example, is there low liquidity in any of the underlying funds? Is this important to you as an investor or for your client?

Another issue for passive funds investing in less liquid alternative asset classes is that they will find it more difficult to track their stated indices. As an asset with low liquidity will not come onto the market as often, these tracker funds may not be able to find the required exposures to track the index, or incur high transaction costs in the process. To measure this effect, an investor should pay attention to the passive fund’s OCF and R-squared (the statistical measure calculated in linear regressions). There have been cases where particularly exotic passive fund OCF’s are at the same level as their active fund equivalents.

Multi-asset passive funds aren't easy 

In contrast to active and passive funds using stock selection only, multi asset passive funds do not necessarily lower the amount of research and due diligence an adviser must complete prior to making a client recommendation. Advisers need to be aware of underlying fund strategies, risks, performance and fees, particularly for alternative asset classes.