With the limitations of both passive and active investing increasingly exposed, attention is turning to hybrid approaches that blend systematic efficiency with fundamental insight.
In her latest update, Lisa Wang, Head of EMEA Investment Strategy at Franklin Templeton Investment Solutions (FTIS), highlights how, by integrating factor-based models with active manager conviction, these strategies seek to deliver consistent, risk-aware alpha, offering investment managers a more flexible building block for modern portfolio design.
JK Galbraith, the esteemed Harvard economist with a string of best-sellers to his name, once remarked that all revolutions “are the kicking in of a rotten door”. Having also served as both a diplomat and a political adviser, he was perhaps better placed than most to make this observation.
In the sphere of investment – and in the world of finance as a whole – passive funds have fuelled arguably the most spectacular and far-reaching revolution ever witnessed. Yet the door that felt the full force of their boot has turned out to be not so rotten after all.
More than 50 years after the first index-tracking strategies were launched, traditional active management is neither hanging from its hinges nor lying in splinters in the hallway. There’s still a place for qualitative insights, which is why the “passive versus active” debate rumbles on to this day.
The pros and cons of these ostensibly opposed schools of thought have long since become wearily familiar. There’s certainly no great need to rehash them at length here.
What is worth discussing, though, is the acceleration of efforts to utilise the best of both worlds. There’s now a fast-growing recognition that a fusion of passive and active – or, to put it another way, of quantitative data and fundamental analysis – can serve as a compelling investment solution.
In particular, how this might be achieved at an individual fund level is a challenge that’s earning ever more attention. Crucially, the broader implications for efficient portfolio construction also demand careful consideration.
Factoring in fundamental insights
The principal attraction of passive funds has always been cost-effectiveness. The principal drawback has always been an inherent inability to beat the market – an issue that tends to come into sharper focus when said market isn’t conspicuously thriving.
Meanwhile, the principal attraction of active funds has always been the prospect – and, ideally, the realisation – of outperformance. The principal drawback, not least in outperformance’s absence, has always been the extra cost associated with active management.
It doesn’t take long to work out that some investors might welcome a combination of cost-effectiveness and potential outperformance. Yet it has taken several decades to develop strategies intended to accomplish this goal and thereby fill the space – because there undoubtedly is one – between passive and active.
In our view, the key to successfully blending a passive-like price point with active-like scope for alpha lies in the innovative application of factors. More precisely, it lies in factoring active managers’ best thinking into well risk-managed, systematic models. Our Core Enhanced Equity Funds offer an illustration of how this can work.
As well as quality, value, sentiment and alternative – the last of which makes use of unconventional data sources – these strategies employ a fifth factor, conviction, which is extracted from our active managers’ research-intensive stock selection. The goal is to introduce more company-specific insights and idiosyncratic return drivers by systematically analysing how fundamental managers allocate risk within their portfolios – rather than simply replicating their holdings.
The process produces aggregated “conviction scores” for all the equities in a particular investment universe. Given the strength and distinctiveness of this signal, we expect conviction to be a significant contributor to alpha over time.
Improving overall portfolio construction
Although the conviction factor seeks to generate additional alpha, the objective isn’t to “shoot the lights out”. Our Core Enhanced range targets 1.25% tracking error, which typically results in a realised tracking error of 1-2% under normal market conditions.
In many respects, what’s more important is the ability of strategies like these to shape the bigger picture. We believe a “best of both worlds” approach can play a sizeable role in determining overall thinking about risk.
Striving for above-market returns while reducing deviation from underlying indices is itself likely to benefit many investors. But having this kind of balance at the heart of portfolios can also free up “risk budget”, which can then be devoted to more specialised active managers.
Does all this constitute a full-blown revolution, whether by Galbraith’s criteria or otherwise? Not really. No doors, rotten or not, are being kicked in. It’s more a case of new doors being gently opened – and, in tandem, new opportunities being created.
In our opinion, this is a natural evolution – one that builds on many years of progress in the field of quantitative investing. It’s not a matter of replacing existing products: rather, it’s a matter of adding to and complementing them.
Traditionally, one school of investing has been seen as wide but shallow and the other as deep but narrow. Today, by using both the predictive power of systematic models and the unrivalled acumen of fundamental research, investors can at last have width and depth at the same time.
Lisa Wang is Head of EMEA Investment Strategy at Franklin Templeton Investment Solutions (FTIS).
