Actively Passive? A Deeper Look

Actively Passive? A Deeper Look

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ollowing up on "Part One" published last month (Actively Passive? A Longer Look), this article explores in greater depth a variety of portfolio management (i.e. rebalancing) strategies involving asset classes which represent commonly utilized indexes. Inasmuch as indexes are generally defined as passive investments this study examines the potential added value of actively managing passive assets.

In last month's issue, ten assets and 18 portfolio management protocols were studied over the 25 year period from 1978 through 2002. Of the 18, there was one passive management approach (i.e. buy-and-hold) and 17 active management protocols. This article adds an additional 21 "active" portfolio management protocols. Annual return data were obtained from Morningstar's Principia software. All returns reported here are pre-tax, nominal (pre-inflation) figures. For simplicity sake, it was assumed that these active portfolio management protocols were executed within a tax-sheltered account.

The results of this study are reported in Figure 1, but as it is a fairly dense table some explanation is needed. The first 10 rows are the individual assets included in the study. (The reader can refer to last month's article to see the year-to-year returns for each of the 10 primary assets.) The 28 rebalancing protocols comprising the bottom portion of Figure 1 consist of seven from the analysis reported last month (as noted by bold, italicized font) and 21 additional protocols introduced in this study. Columns 1, 3, 5, 7, and 9 report cumulative returns in 5 year intervals starting in 1978, with columns 2, 4, 6, 8, and 10 listing their rank "finish order" based upon cumulative return.

For example, the Wilshire Small Value Index had a 5 year cumulative return of 22.0% as of 1982 which ranked it 3rd highest among the 10 indexes. By 1992, it had a 15 year cumulative return of 17.7% which ranked 1st among the indexes. Column 11 is the summation of the five separate cumulative return ranks (where the lower the sum the better). The benchmark indexes were ranked separately from the 28 rebalancing protocols.

Columns 12-22 report on rolling returns over distinct 5 year periods (with no overlap) along with the rank ordering of each. For example, Wilshire Large Growth had a 15.6% average annual return between 1978 to 1982 which ranked it 4th highest among the 10 assets. Between 1983-1987 it had a 15.1% average annual return (also 4th best). During 1998-1992 Wilshire Large Growth was ranked 1st with an average annual return of 16.5%. Column 22 is the summation of the 5 "rolling" return ranks. Column 23 is the sum of columns 11 and 22. Column 24 is the standard deviation (i.e. volatility) of the five rolling returns (columns 12, 14, 16, 18, 20). Column 25 is the rank ordering of the standard deviations. Finally, column 26 (in blue) is the sum of all ranking scores (columns 11, 23, 25). The benchmark indexes and the 28 rebalancing protocols in Figure 1 are listed on the basis of their "Sum of All Ranks" score (column 26) in ascending order (where the lower the number the better).

Using standard deviation as a surrogate measure for risk is fairly common, however using the standard deviation between five separate rolling returns is somewhat unusual. Nevertheless, doing so provides an intriguing view of the volatility of sequential "period" returns (in this case, five 5-year periods).

A familiar rebalancing protocol discussed last month was equal weighted annual rebalancing. This is a very straight forward approach which reallocates assets each year so that each asset has the same starting dollar balance. Introduced this month is a simple tweak to this familiar theme, namely annual rebalancing among the nine best assets from the prior year (#16 in the leftmost column in Figure 1), rather than among all ten assets (#25 in Figure 1). Very simply, it is annual equal rebalancing with the prior year's laggard tossed out. This subtle adjustment produced a 25 year average annual return of 12.5% compared to 11.9% (see column 9). The volatility of the portfolio (as measured by standard deviation of rolling returns) was reduced from 6.0% to 5.8%. This simple tactic added value in the truest sense - higher return with reduced volatility of return.

The remaining 20 active management protocols simulated the notion of "core and satellite" portfolio design. The general idea is that a particular asset or cluster of assets form the core of the portfolio. Added to core are "satellite" assets which usually have low correlation to the core or offer added value in a variety of ways, generally via higher potential return. There were two management options for each of the ten assets, as illustrated below using T-Bills.

1) 20% T-Bill Core, 80% rebalanced among remaining 8 assets (asset with lowest return in prior year removed)

2) 20% T-Bill Core, 80% rebalanced among 3 assets with the highest return in prior year

The two management protocols outlined above involve annual rebalancing. Using #1 as an example, the portfolio is rebalanced at the start of each calendar year so that T-Bills represent 20% of the portfolio value and the remaining 80% of the portfolio is equally spread among the remaining 8 best assets. Now, to the results…

The most attractive active management protocol, on the basis of having the lowest "Sum of All Ranks" score (column 26) was one in which annual rebalancing maintained a 20% core commitment in the Wilshire Small Value index with the remaining 80% of the portfolio equally allocated among the "Best 3 Assets from Prior Year". This particular rebalancing protocol never generated the highest 5 year rolling return, but was consistently in the top 8.

In stark contrast is the protocol of 20% Pacific core, 80% in Best 3 from Prior Year (#11). It had the highest 10 year cumulative return, but only the 9th highest 25 year cumulative return. Even more noteworthy is its behavior over the rolling 5 year periods. In the early periods (1978-1982 and 1983-1987) it had very high returns and excellent ranking but then fell to the bottom of the group in the latter three 5-year periods. Such a pattern illustrates the benefit of consistent returns rather than wide swings in return. Assets and portfolios with high volatility of return may generate acceptable long-run performance, but because of volatility, clients may not stick around long enough to experience the long-run returns.

From these results of this particular 25 year period, rebalancing into last year's underperforming assets does not generate competitive results -- as observed by the three lowest ranked protocols. There was, however, one five year period (1983-1987) during which investing all assets each year into last year's loser had reasonably good outcome (see #28 and columns 14-15). That being said, leaving last year's loser(s) alone is advisable.

Of the 18 management protocols introduced last month 16 could be characterized as an annual rebalancing approach which involves making significant and dramatic shifts in the portfolio on an annual basis (with the exception of the buy-and-hold approach and equal annual rebalancing). It is instructive to note that these dramatic approaches fared poorly against the 20 "core and satellite" protocols introduced in this article. Of the seven original protocols included in this current analysis, only one finished in the top 20 (#2, Best 3 Assets from Prior Year).

Such a bold approach ignores the concept of maintaining a core from year to year and simply plays upon momentum. Nevertheless, doing so generated the 3rd highest 25 year cumulative return, but at the price of higher return volatility (a rank of 24th in column 25 equates to the 4th highest risk level). However, and this is a key point, 8 out of the top 10 finishers in Figure 1 utilized the "Best 3 Assets from Prior Year" as the "satellite" portion of the portfolio. Thus, an asset that may not be advisable as the core of a portfolio - due to volatility concerns - may be an excellent choice as the satellite portion.

A summary is in order. Based upon the 25 year period studied:

U.S.-based stock appears to be a better choice as the "core" of a annually rebalanced portfolio than U.S.-based non-equity assets or non-U.S. equity assets.

U.S.-based small value stock is a more attractive core portfolio asset core than U.S.-based small growth stock. Compared to the Wilshire Small Growth Index, the Wilshire Small Value Index had superior return rankings in 4 out of the 5 cumulative periods and in 4 out of 5 rolling periods with 7.4% less volatility.

U.S.-based large value and large growth stock are essentially equivalent as a core portfolio asset. Though annual differences in performance and volatility will exist, such differences are minimal over time frames of 5 years and longer.

A REIT Index (in this analysis, the Wilshire REIT Index) is an excellent choice as the core for a multi-asset portfolio. A primary reason for this is its low correlation to other commonly utilized portfolio assets.

Portfolio returns are enhanced when the satellite portion of a portfolio utilizes a small number of momentum assets, whether equity or not (e.g. 3 best assets from the prior year). Doing so, however, increases volatility of return.

Volatility of return is significantly reduced by rebalancing across a wider variety of "satellite" assets, but doing so generally reduces return.

There is little evidence that explicitly overweighting under-performing assets in a rebalancing protocol leads to acceptable long run results. However, under-performing stocks often populate the portfolios of value-based equity assets (i.e. mutual funds) hence it is reasonable to assume that some degree of overweighting of laggards exists when assembling a portfolio using value-based core assets.

In conclusion, these results offer only one slice of insight. For instance, changing the weighting of the core portfolio asset to a percentage other than 20% would produce differentials in the rankings. This much appears clear: active portfolio management protocols which go beyond equal annual rebalancing provide an opportunity to generate consistently higher returns at comparable (or lower) levels of volatility.

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Craig L. Israelsen is an Associate Professor in the Department of Consumer and Family Economics at the University of Missouri-Columbia (http://www.missouri.edu/index.cfm) where he teaches courses in Personal Finance and Family Living. He holds a Ph.D. in Family Resource Management from Brigham Young University. He received a B.S. in Agribusiness and a M.S. in Agricultural Economics from Utah State University. Primary among his research interests is the analysis of mutual funds. He writes monthly for Financial Planning magazine.