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Vanguard framework takes the emotion out of the active-index choice

Vanguard | 24 October 2017


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Investors deciding how to allocate their portfolios across actively managed and index investments should follow clear process to avoid arbitrary decision-making, according to a new white paper from Vanguard Australia.

The newly published white paper, Making the implicit explicit: A framework for the active-passive decision, outlines a clear process that investors and advisers can follow when deciding how to implement asset allocation across active and index strategies.

The decision-making framework, which was developed by Vanguard's global Investment Strategy Group, targets four variables to help investors consider when deciding how to implement index, active, or a combination of both, for a given asset class in their portfolio: gross alpha expectation, cost of active management, active risk, and risk tolerance.

“Discussions about active and index investing can draw some strong views from investors and their professional advisers, one way or the other,” Vanguard Australia Head of Investment Strategy, Aidan Geysen, said.

“We see active-passive not as a debate, but as an asset allocation decision, and this framework gives investors a clear process to help them determine the active and index allocations within their portfolio.”

FOUR VARIABLES FOR CONSIDERATION

Gross alpha expectation: the expected outperformance of a given active strategy

Cost of active management: management expenses, transaction fees and other costs associated

Active risk: the potential for underperformance by a given active strategy

Risk tolerance: an investor's tolerance for an active manager's potential underperformance

The paper highlights that the portfolio construction process begins with establishing an appropriate strategic asset allocation, before the evaluation of active and index products.

Vanguard's decision-making framework aims to help investors think more deliberately about their expectations and the risks they're willing to accept, with a focus on how active manager returns can deviate from broad market benchmarks, and how to evaluate factors like conviction, costs and risk in deciding whether an allocation to an active strategy is an appropriate way to implement their asset allocation.

“Investors will invariably have different goals, return requirements, time horizons and risk tolerance, and so whether or not a higher allocation to active is appropriate can differ greatly,” Mr Geysen said.

“In some cases, a higher allocation to active may be appropriate when expected alpha outweighs management costs, when an investor is comfortable with the level of risk being taken, and when the investor has the discipline to stick with an active strategy through periods of underperformance. But an investor can still choose to balance that active risk with an index component in their asset class exposure, accounting for potential underperformance.

“In the end, choosing between active and index isn't a philosophical decision – it's part of the asset allocation process. The ideal choice is the one that best aligns with an investor's unique goals.”

For more detail on Vanguard's active and index selection framework, as well as the underlying qualitative and quantitative analysis, please see the full whitepaper online.

FLOWCHART: THE ACTIVE-PASSIVE DECISION