Practical Applications of Bridging the Gap: Adding Factors to Passive and Active Allocations

Practical Applications Summary In Bridging the Gap: Adding Factors to Passive and Active Allocations, which appeared in the 2018 Quantitative Special Issue of The Journal of Portfolio Management, Anil Rao, Raman Aylur Subramanian, and Dimtiris Melas (all of MSCI, Inc.) argue that asset owners should use risk budgeting to determine the optimal mix of active and passive investments. To support this assertion, the authors examine the effects of different possible active, passive, and factor (top-down or bottom-up) allocations when the active managers have high tracking errors. The authors also examine the effects of using a minimum-volatility strategy to de-risk the equity program. Ultimately, they found that the optimal allocations were around 40% passive, 30-40% active, and 20-30% factor allocation, with differences in funding source and risk allocation.