A Solution for Overdiversification: Low Tracking Error Active Strategies

Abstract

Low tracking error active strategies (often called enhanced active strategies) have fallen out of favor in recent years as investors—keen to avoid wasting money on so-called closet index funds—have gravitated toward higher-risk, more-concentrated strategies or very low-cost index investing. We believe that, compared with other active strategies, enhanced active strategies are considerably underrepresented today and that many investors would benefit from exploring their potential. Recent research has shown that large investors are unable to adequately diversify their active allocations because of policy requirements and—crucially—capacity constraints. Because they are applying an overly narrow, manager-by-manager analysis of active share or active risk, many investors believe that the total risk exposure and return potential of their active allocations justify the fees they are paying for active management. They are often wrong. Our research demonstrates that enhanced active funds, with their significant capacity advantages, can be a highly effective tool to combat the overdiversification of active allocations. As such, we believe that investors should take a broad view of their active portfolios and consider the role that enhanced active strategies can play as a more desirable alternative to highly concentrated active management.

TOPICS: Portfolio construction, passive strategies, performance measurement