Equity asset allocators have to juggle a number of objectives. Chief amongst them are the goals of generating superior after-cost relative returns and keeping relative risk low, two goals that are not entirely compatible.
Many asset allocators try to address this concern with a so-called core-satellite approach, dividing their equity allocation into two main categories: The majority of the funds are invested passively to replicate broad market indices and achieve market returns at low relative risk and low cost. A smaller portion – the satellite – is invested in highly active strategies (HAR) with high relative risk and high expected outperformance.
This approach may rest on a critical and perhaps mistaken assumption: That HAR strategies on average use their risk budgets more efficiently and produce higher risk-adjusted returns than low active risk (LAR) strategies and therefore, there is no benefit to the overall portfolio from diversifying across the active risk spectrum of passive, LAR and HAR strategies. Our research indicates this assumption is incorrect, and that particularly for an asset allocator with an overall tracking error budget of between 1% and 3%, adding LAR strategies with moderate tracking error may result in higher information ratios for the overall portfolio than core-satellite strategies that rely entirely on HAR to generate alpha. We recommend adding LAR strategies to the equity portfolio rather than an over-reliance on pure passive strategies and thus combine passive, LAR and HAR for better results.