Proper asset allocation is the cornerstone of prudent investing. But once the allocation is made, fiduciaries have a critical decision to make: How should each asset class be invested? There are two main choices: active or passive management. Both have advantages and disadvantages. In fact, for portfolios in excess of $5 million, fiduciaries often use a combination of these approaches.

Because of the greater range these days of investment opportunities and methods, it's critical that fiduciaries understand all their options — and what's appropriate under each circumstance.1 Here's a guide:

DECISIONMAKING

In active management, a manager's skill in selecting investments ideally results in returns that exceed the market. Passive management looks to replicate the risk-and-return characteristics of a market segment (asset class) or an index by mirroring its composition. There also are types of passive investments — sometimes referred to as “enhanced beta investments” — that use derivatives to enhance returns or manage risk more effectively than purely passive management.

So how do fiduciaries decide which path to take?

First, consider the type of asset class that is involved. Then, consider:

  • How are adjusted risk returns maximized?
  • How is duty delegated under the prudent investor standards (will it be as an active manager of funds or the manager of index funds)?
  • What value does a manager offer (what is the net investment return after fees and taxes and adjusting for risk)?
  • How does the manager diversify the fund (that is to say, manage risk)?
  • What is the proposed fund's tax efficiency?
  • What securities laws are involved (for example, the accredited investor and qualified purchaser rules)?

These considerations carry different weight, depending on the type of trust involved. For instance, trustees of a short-term grantor-retained annuity trust (GRAT) or a long-term grantor trust may weigh some of these considerations differently.

A fiduciary may choose between active or passive management depending on whether an asset class is considered “efficient” or “inefficient.” (See “Alpha vs. Beta,” p. 40.)

Passive management may be better suited for efficient asset classes — such as U.S. large-cap and U.S. bonds — that are heavily researched and intensely traded.

For such efficient markets, active management can be counter-productive. It's likely to generate more short-term gains, higher fees and higher transaction costs.

Instead, active management makes the most sense when “inefficiencies” abound, that is, there are disparities between intrinsic value and market price. Among traditional investments, the richest opportunities for active management lie in U.S. small-cap, foreign securities and emerging markets, where “mispricing” is more likely.

But, as we've seen of late, active management also can reap huge rewards in alternative asset classes, such as hedge funds and private equity. Of course, fiduciaries must be particularly careful in choosing a manager to select and manage these potentially riskier asset classes within the trust portfolio.

ACTIVE MANAGEMENT

Active management allows investors to benefit from a manager's skill. Active managers use fundamental, technical and macroeconomic analysis as well as proprietary trading models as they seek to generate returns that exceed the market. The active manager's goal is to outperform applicable benchmarks on a risk-adjusted basis. For example, an active manager may invest primarily in small-cap equities and measure his success by how well he outperforms relative to the Russell 2000 (U.S. small-cap index fund) net of fees, taxes and transaction costs as his benchmark.

That measurement of an active manager's success is captured by “alpha,” the mathematical estimate of the return on a security or portfolio when the return on the applicable benchmark is zero. The active manager's job is to consistently exploit market inefficiencies and identify unique, high-performing investments attempting to achieve better results than the appropriate benchmark after accounting for risk. Active managers are able to extract alpha on a more persistent basis from asset classes such as private equity, certain hedge funds (for instance, equity long-short funds and global macro/managed futures funds) and small-cap, mid-cap and emerging markets.

To achieve better-than-average results, active managers usually engage in significant active trading. Actively managed portfolios and funds often have a turnover of 50 percent to 100 percent of their asset positions. Naturally, then, fees for actively managed investment strategies are typically higher than passive investment strategy fees.

Be aware, too, that active trading can create tax inefficiencies that are inappropriate for some trusts. For example, active trading may create short-term gains (with their higher tax rates) and may accelerate taxes due. Clearly, fiduciaries need to factor in these higher fees2 and tax effects when deciding on management styles.

It's also important to recognize that while some active managers may have access to more information and consistently use this data to outperform the markets, delivering alpha is not the norm for active managers dealing with U.S. large-cap equities. In fact, one study shows that over longer-term horizons of 10-to-15 years, about 60+ percent of active managers in the U.S. large-cap space tend to underperform the passive benchmark net of fees.3 Moreover, virtually all median quartile managers over short, intermediate and long-term periods deliver returns (net of fees) below the underlying U.S. large-cap benchmark. That's why passive investment strategies often provide investors with a more cost-effective and attractive means of obtaining exposure to that market.

Investors often find it difficult to identify strategies or select active managers to deliver returns that systematically outperform the market. Given this reality, fiduciaries need to carefully evaluate active managers, selecting only those who have demonstrated an ability to perform in the top quartile on a persistent basis.

But fiduciaries also need to decide whether even these managers' returns (net of fees, taxes and transaction costs and adjustments for risk) justify the higher fees involved in active management. Indeed, given the greater portfolio turnover, tax inefficiencies and fees, active managers must generate higher risk-adjusted returns to deliver results equivalent to the passive manager.

To put this in perspective, let's compare the growth of assets over a 10-year investment horizon for both active and passive managers. Let's assume a strategic return estimate of 9.6 percent per annum for a passively managed U.S. large-cap portfolio. Based on an annual strategic return estimate of 9.6 percent, an active manager with turnover of 50 percent, in which 75 percent of the realized gains are subject to long-term capital gains tax treatment and fees of 70 basis points per annum, must generate alpha of 1.22 percent each year to break even on an after-tax and fee basis with a passively managed portfolio with zero turnover and annual fees of 0.10 percent per annum.

Several actively managed strategies require a portfolio of at least $5 million in investable assets to satisfy the accredited investor and qualified purchaser rules for trusts, family companies and private foundations.4 The allocation to private equity and hedge funds, however, may be integrated more easily with portfolios with at least $10 million. Those portfolios can more easily diversify their holdings to increase alpha opportunity to offset increased fees and potential income tax inefficiencies.

PASSIVE MANAGEMENT

Passive investments typically are found in portfolios of all sizes. Passive management should be considered as a method of investing for trust portfolios.

The objective of passive management is to replicate an underlying index as closely as possible (for example, Standard & Poor's 500 Index or Dow Jones STOXX 50 Index.) That's why passive investment management is often referred to as “indexing.” This management style is considered “passive” because the manager does not make decisions regarding the securities to be purchased, but rather simply purchases the same securities, with the same weightings, as the underlying index. The goal of passive investment management is to match the return of a market (beta) by investing in a basket of securities that replicates the performance of this underlying benchmark index. Passive management can only get exposure to beta.

Beta is a mathematical measure of a security's or portfolio's volatility relative to the market. A beta of 1.0 indicates that a given security closely follows market movements. Beta may also be thought of as a measure of an asset's return sensitivity to market returns, that is, its non-diversifiable risk or market risk.

A security that demonstrates more volatility than the market will have a beta above 1.0. Higher beta stocks imply greater volatility, are considered to be more risky and are expected to provide potential to generate higher returns. In contrast, lower beta stocks demonstrate less volatile price movements, are viewed as less risky and, as such, are expected to generate a lower return relative to the relevant benchmark.

Fiduciaries and their investment advisors may be able to construct a passive management portfolio suited for a particular trust's asset allocation model and specific circumstances. Passive investment management or indexing generally involves minimal trading; hence, there are lower fees to administer. Therefore, realized gains tend to be long-term instead of short-term. Typically, the only time trading occurs is to capture the weighting and composition shifts of the underlying benchmark index components. There are trusts that at first glance may appear to be well-suited for passive management. Fiduciaries, however, should note that passive management may not be the best method in circumstances that may include:

  • the need to maximize dividend yield;
  • when municipal fixed income or state-specific municipal bonds are appropriate;
  • the need to diversify a concentrated low-basis appreciated holding or a large concentration in a certain sector;
  • the need to manage restricted securities; and
  • the desire to take advantage of tax-loss harvesting to minimize income taxes.

Fiduciaries also should realize that it is easier to diversify alpha than beta. This can be evident with beta in periods of financial distress when correlations among all asset classes tend to increase (and assets decrease in value) and the benefits of diversification decrease. Alpha is easy to diversify because there can be several sources of alpha (arising from the manager's access or ability to analyze data.) These sources are not correlated with one another. Even if one source of alpha is not performing well, it does not have any influence on other sources of alpha in the portfolio. In other words, if one manager's stock picks are not performing well, it does not mean that another manager in the portfolio will perform badly as well.

ENHANCED BETA

A new class of structured investments, enhanced beta, provides investors with a viable alternative to passive investment, while allowing potentially greater participation in the upside potential from market exposure. This alternative class of investment instruments is designed to outperform the index, as a benchmark, in rising markets and, under many situations, provide downside protection in declining markets. In effect, these alternatives to passive index investment are designed to systematically outperform an underlying benchmark index. In contrast to active managers who rely on technical and fundamental analysis to outperform the market, an enhanced beta structured product utilizes derivatives and capital markets techniques to capitalize on the key factors that deliver more effective risk-adjusted returns on a desired benchmark index representing exposure to a given asset class (for example, U.S. mid-cap and European large-cap.) Enhanced beta investments are structured to benefit from two return components that drive the performance for an underlying benchmark index: (1) price appreciation, which is the result of earnings growth, and (2) dividends. The dividends are taxed at the federal and state level, and the after-tax amount is reinvested in the index to leverage future price appreciation. Price appreciation accounts for the majority of a benchmark's index return, typically close to 80 percent, and the balance, or 20 percent, is the result of dividend reinvestment.

Utilizing capital markets techniques, future dividends are monetized and used to purchase options on the benchmark index. Call options are used to provide leveraged participation on potential upside price appreciation, and put options are used to provide partial downside protection to hedge against declining markets. In effect, these derivative and capital markets techniques can be used to generate excess returns with a moderate increase in risk.

The question becomes whether it's appropriate to forego future dividends in exchange for an option or leveraged position on future price appreciation. Historical backtesting and Monte Carlo analysis (that is, forward-looking analysis using random numbers to generate probability distributions) can be conducted to measure how enhanced beta compares to a relevant underlying benchmark. Attractive enhanced beta should exhibit a high probability of outperforming the benchmark index on a net-of-fee and cost basis.

In other words, enhanced beta can provide a cost-effective method of providing better returns than pure passive management for those fiduciaries who can avail themselves of these investment opportunities.

EXAMPLE

Let's see how using an enhanced beta structure fares. Assume the asset allocation for a trust calls for a portion of the portfolio to be invested in international equities. The trustee understands that the asset class will produce favorable returns, but is concerned about market volatility due to geo-political factors. She chooses to use an enhanced beta investment that will provide favorable returns, but provides for certain downside protection because the investment contains puts.

Using a Monte Carlo simulation, we compare the expected returns on the DJ STOXX 50 Total Return Index (STOXX 50 Total Return Index)5 with an enhanced beta STOXX 50 note. (See “When Enhanced Beta is Better,” this page.)

Our analysis assumes a forecast for the STOXX 50 Total Return Index of 8.4 percent over a five-year investment horizon. The Monte Carlo analysis shows that the enhanced beta STOXX 50 note has a greater than 64 percent probability of outperforming the STOXX 50 Total Return Index over a five-year period. The expected average total cumulative return for the note is 55.4 percent, versus 45.4 percent for the underlying total return index. This represents an annualized return of 9.2 percent for the STOXX 50 note, 1.4 percent higher than the STOXX 50 Total Return Index.

This higher expected return would expose the investor to greater volatility in return. However, the probability of the higher return may be worth the incremental risk. While the note's annual standard deviation is 21.2 percent, as compared to 18.7 percent for the total return benchmark, when evaluated with appropriate risk/reward measurement tools, the note may provide the fiduciary with an investment opportunity that closely matches the trust's goals and objectives.

Additionally, a fiduciary should choose a particular risk measurement to evaluate available investments, depending on the trust's risk tolerance. In our example, two commonly used measurements of risk-adjusted returns, the Sharpe Ratio6 and the Sortino Ratio,7 demonstrate the note more than compensates for the additional risk. The Sharpe Ratio, which measures risk-adjusted returns based on both upside and downside volatility (standard deviation), is 0.85 for the STOXX 50 Total Return Index, slightly higher than the 0.75 level for the note. This statistic suggests the total return benchmark's risk-adjusted returns may be slightly more favorable. However, the Sortino Ratio, which uses only “bad” or downside volatility instead of standard deviation, is 2.46 for the STOXX 50 note, versus 1.99 for the total return benchmark. The higher Sortino Ratio for the note implies it has a higher probability of generating positive returns and a lower risk of loss.

INDEX BASKETS

Structured investments, which utilize embedded derivatives to create payout profiles that are different from traditional asset classes, may be configured to generate returns referenced to a variety of underlying asset classes as its benchmark. Basket strategies consisting of similar or different asset classes may be combined to achieve beta exposures against multiple markets. For example, structures may be engineered by combining option exposure to the MSCI EAFE Index (international developed country equities), Nikkei 225 Index (large-cap Japanese equities), Russell 1000 Index (large-cap domestic equities) and Dow Jones AIG Commodity Index to create hybrid exposures.

Also, varying the weightings used in hybrid structures can allow an investor to obtain the amount and kind of beta exposure desired. Fiduciaries may find it attractive to invest in index baskets that may be configured to specifically compliment the needs of the trust's portfolio by mitigating volatility, increasing diversification and potentially generating greater returns.

Note that some enhanced beta investments may be available only for trusts exceeding $5 million dollars, in order to satisfy accredited investor and qualified purchaser rules. The fiduciary must determine when it's reasonable to assume greater risk from using derivatives that alter payout profiles but allow for greater participation in the upside potential for a given asset class. Fiduciaries should determine whether to use enhanced beta structures based on whether the risk-adjusted return is advantageous relative to alternatives, while satisfying the portfolio's objectives and risk tolerance.

SPECIFIC TRUSTS

Within the context of asset allocation models, different size and type of trusts may favor either a large concentration of one management approach, or a combination of approaches. For example, those trusts that are viewed as investment-driven estate-planning techniques, like GRATs and grantor trusts (with sales or loans), may look to management approaches that exceed benchmarks. Therefore, those trusts will tend to hold a higher concentration of active management or enhanced beta investments. This may include using an enhanced beta structure, such as a structured note to increase the likelihood that returns will exceed the Internal Revenue Code Section 7520 rate or applicable federal rates (AFRs) under IRC Section 1274(d) with additional risk proportionate to the increased return potential. For trusts that exceed $10 million, top quartile, active managers may be available for grantor trusts (with long-term horizons.)

  • GRATS — Typically, private equity will not be a suitable asset for a GRAT, because its returns generally occur in years five-through-eight and capital calls are required during the first years that create liquidity issues for the GRAT. However, private equity can be incorporated effectively into long-term grantor trusts. The grantor can provide loans at the AFRs to assist the trust in meeting capital calls. Presumably, the investment returns will exceed the AFRs on the loans.

  • Unitrusts/dynasty trusts — For unitrusts that seek growth and liquidity over typically longer time horizons, the portfolios may include structured notes (enhanced beta), passive management, and active managers for those trusts with a minimum of $5 million to $10 million. For trusts under $5 million, passive and active management can be appropriate, depending on suitable asset classes and particular circumstances. For trusts (such as dynasty trusts) with at least $5 million in investment assets that are primarily looking to grow in the initial years of the trust, the trustee will seek moderate growth, preservation of principal and less liquidity. So the portfolio may include longer-term investments such as active management with private equity, hedge funds and longer-term structured notes.

  • Marital trusts — A trustee's investment strategy for marital trusts will differ, depending on the spouse's desire for net income. Some spouses look to the marital trust for substantial amounts of net income at the expense of long-term growth. Others want less income and consent to the trustee investing for growth to benefit future generations. Because asset allocation can vary with marital trusts, so too will the use of passive or active management. For instance, passive management should be given proper consideration for the fixed income portion of the portfolio. However, for some states, passive municipal bond replication may not be available.

  • Annuity trusts — These types of trusts could benefit from an enhanced beta's structured note that provides for principal protection. The principal protection feature of the note typically reduces certain upside potential. However, the ability to protect the trust assets on the downside can be important in declining markets so that the trust principal will not be significantly reduced (especially in the initial years of the trust.) The trustee wants to avoid the likelihood that the trust's assets are depleted over time due to the fixed annuity payments required to be made regardless of the value of trust assets.

Trustees must make informed, deliberate decisions about whether to use active or passive management. These decisions will be considered within the context of the asset allocation model and will drive manager selection and trust investments. Each type of trust, time horizon and trust objective will have to been taken into account as to what is appropriate in every situation.

Citi Trust is a business of Citigroup, Inc. (Citigroup). This article is for informational purposes only, and does not constitute a solicitation of any kind. Opinions expressed are those of the authors, and may differ from the opinions expressed by departments or other divisions or affiliates of Citigroup. Although information in this article is believed to be reliable, Citigroup and its affiliates do not warrant the accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. Neither Citigroup nor any of its affiliates provides tax or legal advice. Clients should consult independent counsel/tax advisors in connection with matters covered in this article.

Endnotes

  1. See Uniform Prudent Investor Act, Section 171, comment h (power to make investments) and Section 227, comment j (delegation of duty).
  2. The Internal Revenue Service has issued a proposed regulation, Prop. Reg. Section 1.67-4 that will clarify that investment fees for trusts cannot be fully deducted but must be subject to the 2 percent floor for miscellaneous itemized deductions under Internal Revenue Code Section 67(a). The ability to use investment fees as allowable deductions may be significantly reduced and affect the after-tax returns.
  3. See Zephyr Associates “Style Advisor Program,” through June 2007, at www.styleadvisor.com. Past performance is not indicative of future results. Actual returns may vary. For this analysis, we plotted the returns of the universe of separate account managers over the past 10 and 15 years. For the purpose of this analysis, we assumed total fees and transaction costs of 0.70 percent for active management and 0.10 percent for a passive index fund. Comparing the benchmark (Russell 1000 Index for large-cap U.S. stocks less 10 basis points for fees) with the return of the median manager helps measure the performance gap between the median active manager and the benchmark, that is to say, the passive strategy. Among large-cap managers, we analyzed only “core funds” — those whose holdings include both low-priced stocks and high-growth — in order to avoid a “growth” or “value” style basis.
  4. For a more complete discussion, see Douglas Moore, “Alternative Investments — The Fiduciaries' Primer,” Trusts & Estates, June 2007, at p. 42.
  5. DJ STOXX 50 Total Return Index (Bloomberg ticker: SX5R) is the total return version of the Dow Jones STOXX 50 Index. The Dow Jones STOXX 50 (Price) Index is a capitalization-weighted index of 50 European blue-chip stocks. The equities use free float shares (unrestricted shares sold on the open market) in the index calculation. The index was developed with a base value of 1000 as of Dec. 31, 1991.
  6. The Sharpe Ratio is a return/risk measure developed by William Sharpe. “Return” is defined as the incremental average period return of the investment over the risk-free rate (or the minimum acceptable return.) “Risk” is the standard deviation of the investment returns, where standard deviation is a measure of how much the values in a distribution vary from the mean of the distribution.
  7. The Sortino Ratio is a return/risk ratio developed by Frank Sortino. Return is the incremental compound average period return of the investment over the risk-free rate (or the minimum acceptable return.) Risk is the downside deviation below the risk-free rate, where the downside deviation measures the variation of the investment returns that fall below the risk-free rate.

ALPHA VS. BETA

To understand a manager's performance, look at whether he takes on more or less risk than the benchmark (beta) or simply picks good sectors and stocks to invest in (alpha)

A manager who takes on more risk than the benchmark (a “high beta” manager) will outperform when the market is rising, but underperform when the market is falling. This is exactly what happened when many of the high-fliers of the late 1990s came crashing down.

In contrast, a manager who consistently adds alpha should be able to outperform the market in any environment.

Here's why alpha matters: Manager A has a beta of 1.5 and no alpha, while manager B has a neutral beta of 1.0 and generates 4 percent alpha. If the market rises by 8 percent, managers A and B both return 12 percent.

If you are not looking at alpha and beta, it's impossible to tell the difference between these two managers.

Unfortunately, the difference becomes clear in a down market. If the market drops by 8 percent, high beta manager A is now leveraged to a falling market, declining by 12 percent. However, high alpha manager B still adds 4 percent over the benchmark and declines by only 4 percent, or two-thirds less than manager A.

UP MARKET
Manager A (High Beta) Beta = 1.5 Manager B (High Alpha) Beta = 1.0
Benchmark Return 8% 8%
Excess Beta Return 4 0
Excess Alpha Return 0 4
Total Return 12 12
DOWN MARKET
Manager A (High Beta) Beta = 1.5 Manager B (High Alpha) Beta = 1.0
Benchmark Return -8% -8%
Excess Beta Return -4 0
Excess Alpha Return 0 4
Total Return -12 -4

Monte Carlo simulation is a technique using random numbers to determine the probability that an asset allocation (portfolio) will achieve its financial goals. There is no guarantee that any one of the thousands of Monte Carlo simulations will come true, nor is this the intent of the analysis. If input assumptions are wrong, results may be wrong. Any bias in the input random sample of returns could create significant bias in the results. Simulations in which the distribution tails contribute significantly to the results can take a while to stabilize. Simulations may not generate a stable cross-sectional correlation matrix in a multi-variate space and correlations may not remain stable during the simulation process. Since each portfolio simulation is randomly generated, results generated from Monte Carlo will vary slightly every time the entire process is re-run.

IMPORTANT: The projections or other information generated by this Monte Carlo analysis regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
John J. Grande and Traudy F. Grande, “Develop a sound investment strategy for retirement goals,” Ophthalmology Times (Jan. 1, 2005)