A Spectrum Approach to Active Risk Budgeting

Many institutional investors use a barbell strategy to invest their large-cap equity portfolios. This strategy mixes passive managers (who have no tracking error) with traditional concentrated active managers (who usually have high tracking errors) to moderate the total portfolio's active risk. The authors believe investors can achieve better results by including in the mix low-tracking error structured managers (also known as enhanced-index or benchmark-sensitive managers). They call this approach the spectrum strategy, because it allocates risk across the entire active risk spectrum. The historical analysis shows structured managers have generally achieved higher risk-adjusted returns (i.e., information ratios) than traditional managers. Their relative performance advantage is due to, first, structured managers' focus on risk management (i.e., less noise in the information ratio's denominator), and second, their relative freedom from the no-short constraint (i.e., the no-short constraint is less binding when managers target small active deviations). Perhaps surprisingly, given the expected information ratio advantage, allocations to structured managers should come primarily from the plan's passive allocation rather than from traditional active managers.