By Anil Rao, Raman Aylur Subramanian, and Dimitris Melas, Executive Directors, MSCI.

What is the best way to indroduce a factor allocation to an existing portfolio of active and passive investments without increasing active risk?

How can asset owners integrate an equity factor allocation into their existing roster of active managers? There is no one answer that suits all. The response may be different for each asset owner, depending on its investment beliefs, goals and risk tolerance.

However, we can use a risk budgeting framework to create a core-satellite structure consisting of passive, active and factor allocations. For example, a board of trustees may want to adopt a factor program with the goal of harvesting long-term premia. Investment staff decide to use a top-down factor allocation, with the added restriction of preserving existing managers.

The existing equity portfolio is two-thirds passively managed and one-third actively managed. These capital weights correspond to 150 basis points (bps) of active risk – all of which is consumed by the active managers.

We then gradually fund a factor allocation from the passive allocation, subject to the 150 bps constraint on overall active risk. In the charts below we can see how the passive allocation can be reduced while staying within the overall risk constraint. For example, the top bar chart shows that it is possible to fund a factor program without necessarily defunding active management. A 40% weight to core passive corresponds to approximately 40% and 20% weights to the active and factor allocations, respectively.

The bottom bar chart shows that this set of weights distributes almost all of the active risk to the active managers, implying that deviations in the equity program’s active return will most likely be due to decisions by the active managers.

Source: MSCI.

In our second scenario, a board of trustees again decides to adopt a factor program with the goal of harvesting long-term premia. This time, however, investment staff are given greater discretion in having the factor program compete with active managers for funding and the risk budget.

The baseline portfolio is the same as in the previous scenario, however, the factor allocation is now accomplished via the bottom-up implementation. In the below exhibit, we see a very different outcome for asset owners who choose this method.

A 40% weight to passive results in approximately 30% in both of the factor and active allocations (top bar chart). These weights indicate that staff has higher conviction in factor premia than in the previous scenario. This time, some of the funding for the factor allocation comes from the active managers; in the previous scenario, the factor allocation was funded entirely from the passive allocation.

The lower bar chart shows that the active risk is now more evenly shared between the active and factor allocations. In the previous scenario, the active managers consumed the bulk of the 150 bps risk budget.

Source: MSCI.

In short, asset owners who wish to preserve their existing roster of active managers, and incorporate factor views, might consider a top-down factor implementation. This approach distributes the bulk of the risk budget to active management while funding the factor allocation from the core passive allocation.

Asset owners who wish to preserve their existing roster of active managers, and have high-conviction factor views, might consider a split of capital between active management and a bottom-up factor implementation. This approach more evenly distributes the risk budget to active management and the factor allocation. The factor allocation is partially funded from active management in this scenario.

Lastly, asset owners who pursue a “barbell” strategy between core passive and active management might consider a low volatility factor allocation. This approach can either de-risk the equity program or increase the allocation to active management. These three approaches are summarised below.

Source: MSCI.

This example assumes that the existing equity portfolio that is two-thirds passively managed and one-third actively managed. Active managers (largely value and small-cap) have high tracking error. The total risk budget is 150 bps.

(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)