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Institutional investors are frequently faced with making a choice between active and passive management. The ability to select skilled managers who can add value beyond a comparable passive benchmark may justify the case for active implementation. One fundamental approach toward evaluating active managers is by segregating them based on the region of their investment focus—US large caps, international large caps, global small caps, and emerging markets—and then reviewing the active management opportunity and the past success of active managers in each of these market segments. Our study reveals that both emerging markets and small caps were relatively less efficient, provided a diverse universe for stock selection and exhibited higher return dispersion than other market segments, thereby creating a dynamic pool of potential opportunities for active management. In addition, active managers have been more successful in selecting emerging market and small-cap stocks and have exhibited higher persistence in performance in these markets. TOPICS:Manager selection, equity portfolio management, emerging markets Key Findings • The ability to select skilled managers in opportune markets, those who can add value beyond a passive investment tracking an index, may justify the case for active implementation. • Global small caps and emerging markets offered greater opportunity for active stock selection compared to the US and international large-cap equity segments. • Global small-cap and emerging-market active managers were more successful in adding value over their benchmarks compared to US large-cap active managers, even when results were neutralized for systematic risk factors. Additionally, small-cap and emerging-market managers exhibited higher persistence in performance.

The authors examine how a factor allocation can be integrated into an asset owner’s existing roster of active managers. Using a risk-budgeting framework, they have several findings. (1) Asset owners who wish to maintain their existing roster of active managers and incorporate factor views may consider a top-down factor implementation, funded entirely from the core passive allocation. This approach distributed most of the active risk to active managers. (2) Asset owners who wish to preserve their existing roster of active managers and incorporate high-conviction factor views may consider an allocation between active management and a bottom-up factor implementation. This approach more evenly distributed the risk budget to active management and factors and partially funded the factor allocation from active management. (3) Asset owners who pursue a barbell strategy between core passive allocations and concentrated active managers could implement a low-volatility factor allocation, which may lower the total risk of the equity program, releasing active risk budget that can be deployed to active managers.

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.

Bender et al . discussed six factors – value , low size , low volatility , high yield , quality and momentum – that historically have earned a premium over long periods, represent exposure to systematic sources of risk and have strong theoretical foundations. They also discussed how these factors could be captured through indexation. In this chapter, we turn to the question of how institutional investors interested in factor investing may allocate to and across factors.

This paper is the second in a three-paper series focusing on factor investing. In the first paper, “Foundations of Factor Investing”, we discussed six factors — Value, Low Size, Low Volatility, High Yield, Quality and Momentum — that historically have earned a premium over long periods, represent exposure to systematic sources of risk, and have strong theoretical foundations. We also discussed how they could be captured through indexation. In this paper, we turn to the question of how institutional investors interested in factor investing may allocate to and across factors. In particular, we introduce a new framework for how institutional investors might consider implementing factor allocations through a passive mandate replicating a single multi-factor index. We call this type of allocation a multi-factor index allocation. Multi-factor indexes combine select factor indexes into single mixes created and controlled by the investor. Multi-factor indexes historically have demonstrated four key benefits: diversification, transparency, cost-efficiency via reduced turnover, and flexibility.

Factor investing is based on the existence of factors that have earned a premium over long periods, reflect exposure to systematic risk, and are grounded in the academic literature. Early financial theory established that for stocks, exposure to the market was a significant driver of returns (e.g., the CAPM). Later, researchers like Barr Rosenberg, Eugene Fama and Kenneth French extended the CAPM to include certain systematic factors that also were important in explaining returns. Tilts towards these factors such as Value, Low Size, and Momentum historically produced excess long-term returns and there were strong theoretical foundations behind these factors. Until now, passive investing has focused on capturing market beta through market capitalization weighted indexes. The only way institutional investors could get access to factors was through active management. Indexation is opening a new way for factor investing today by allowing investors to access factors through passive vehicles that replicate factor indexes. MSCI Factor Indexes provide access to six solidly grounded factors — Value, Low Size, Low Volatility, High Yield, Quality and Momentum. These indexes have historically earned excess returns over market capitalization weighted indexes and experienced higher Sharpe Ratios. This paper is the first in a three-paper series focusing on factor investing.

The small cap as a source of equity risk premia has been well documented in finance literature. Although small-cap stocks are often perceived as risky relative to their large-cap counterparts, they have other characteristics that may provide an opportunity for portfolio diversification and return enhancement. In particular, moving beyond the universe of large- and mid-cap stocks into the small-cap segment triples the opportunity set in terms of number of stocks available for investors. Also, there have been pronounced performance disparities between the large- and mid-cap segments and small-cap segments of equity markets. This has motivated institutional investors to seek broader exposure and to make strategic portfolio allocations to small-cap stocks, which is evident from the growth in initial funding to small cap mandates. This research insight presents the characteristics of global, small-cap stocks relative to large- and mid-cap stocks, reviews the role that global small-cap stocks can play for portfolio diversification and return enhancement and examines different investment processes to capture the small-cap premium by comparing active versus passive strategies.

Globalization has brought about a major rethinking of the equity investment. Thought leaders in the industry are questioning the merit of the existing equity allocation practices and are increasingly looking towards an integrated global equity investment process. The partitioned domestic/non-domestic approach to equity investing may have been built on the grounds of segmented economies, high levels of foreign investment restrictions, and heavily domestically-focused companies but its validity is being challenged by a changing and more integrated global equity landscape. Traditional arguments supporting a home bias equity allocation are less defensible and certain leading institutional investors are realizing that the segmentation between domestic and international equities at a strategic level is a legacy that may come with important market timing risks and opportunity costs. A more integrated approach to equity investing may be the next stage in the evolution of investment processes and a natural consequence of globalization. A broad and investable global equity benchmark is an integral part of such a process.