Properly isolating active contribution from passively-available exposures reveals true active risk, persistent security-selection skill, and unintentional risk exposures or gaps.
Equity risk models are designed to measure risk as completely as possible for even the most concentrated portfolios. Popular models today use over 100 underlying risk factors, most of which are not investable. While effective at measuring risk, these models can be complex, expensive, and difficult to interpret...
They are also ill-suited for attribution: knowing that you underperformed because you were over-exposed to momentum or leverage at the wrong time is not terribly meaningful and certainly not actionable...
On the other hand, a model designed specifically for oversight, with a limited number of passive ETF risk factors, measures risk as well for most portfolios, but can also distinguish active contribution (security-selection, timing, and trading) from the impact of passive exposure differences from benchmark.
Consistent differences from the benchmark in passively-available exposures (market, sector, size, value, and bonds for a U.S. model) explain two-thirds of incremental return for the median portfolio.
These passive differences from the benchmark, whether or not intended, are not part of an active manager’s contribution. They can be freely obtained if intentional, or offset in advance with ETFs or through a multi-manager structure if unintentional.
- When properly measured, skill persists. Negative skill strongly persists. Managers with top decile stock-selection skill are twice as likely to outperform in subsequent years. Managers in the bottom decile are more than twice as likely to underperform.
- One-third of active equity funds are closet indexers taking too little real active risk to offset their fees, even with skill. These managers can only be identified with a properly defined risk model.
- Passive exposure differences from the benchmark explain the majority of incremental return for most active portfolios. Unintended exposures can be freely offset.
Equity risk models can be mathematically complex and hard to compare. Fortunately, these models are easily tested..
To evaluate the accuracy of an equity risk model, we compare returns predicted by past factor exposures to subsequent portfolio performance: We measure factor exposures using end-of-month holdings and predict the following month’s return.
The correlation between predicted and actual return measures a model’s accuracy. The higher the correlation, the more effective a model is at hedging, stress testing and scenario analysis, as well as evaluating investment risk and skill.
It’s not necessary to rely on the out-of-sample testing we’ve published; we’re happy to provide passive ETF replicating portfolios for any of your managers so you can evaluate our models’ accuracy against future realized returns.