Enhanced equity strategies, defined
Enhanced strategies seek to provide modest excess returns consistently over time, while closely tracking the characteristics of their reference benchmarks. Enhanced managers strive to limit performance surprises. At the same time, enhanced strategies must take on a small amount of risk compared to the benchmark – spread across hundreds of securities – in order to gain the potential for outperformance. The State Street Active Quantitative Equity team pursues these objectives in its enhanced strategies through an investment process that includes active stock picking using the group’s proprietary stock-selection model.
Enhanced strategies clearly lie between indexed and conventional active strategies in terms of expected risk and expected return; however, there is no single, industry-wide definition of where enhanced funds begin or end on the spectrum. The full range of actively managed approaches, from enhanced through to traditional active approaches, is a continuum. In general, strategies that target tracking error – a measure of active risk1 – in the range of 50 to 200 basis points on that continuum are considered “enhanced.”
Striving to make efficient use of risk
Enhanced strategies are designed to be extremely efficient in their use of risk. The space they aim to occupy in terms of expected risk and return is a kind of “sweet spot,” where each unit of incremental risk added has the potential to yield the greatest return.
This attribute can be useful to investors as they pursue their goal of generating as much excess return as possible while keeping risk tolerable. Whether the focus is on maximizing return for a given level of risk, or minimizing risk for a given level of return, understanding the trade-off between risk and return is critical.
The information ratio
A useful measure of what is sometimes called the risk budget – that is, how efficiently a given portfolio is ‘spending’ risk to gain excess returns – is the information ratio:
Information ratio (Efficiency) = Excess returns/Active risk (Tracking error)
In this formula, “excess returns” are measured as returns above the reference benchmark, while “active risk” is measured in terms of tracking error (which quantifies the divergence between a fund’s returns and those of its benchmark). Actively managed funds by definition seek to diverge from the benchmark, in that they seek outperformance. The greater the active risk a fund takes on in its quest for outperformance, the greater its tracking error is likely to be.
Portfolios with higher information ratios have historically produced more excess return per unit of active risk than those with lower information ratios. Put another way, the higher the information ratio, the more efficiently the portfolio has “spent” risk in order to generate excess returns.
The first incremental additions of risk have the potential to yield the greatest returns per unit of added risk. As a fund takes on more risk, the corresponding return potential tends to diminish – hence the unique efficiencies that enhanced funds can be capable of achieving.
The typical core/satellite approach
Investors pursuing a traditional core/satellite approach to equity portfolio allocation generally build the core using indexed funds and build the satellite out of higher tracking-error actively managed funds. We believe this is not the most efficient use of a portfolio’s overall risk budget.
In this example of a core/satellite portfolio, we limited the categories of potential investments to four: indexed (with active risk, measured as tracking error, of 0.05%),2 enhanced (tracking error of 2.00%), standard active (tracking error of 5.0%) and highly active (tracking error of 6.5%).
In addition, to keep the analysis conservative, we assumed that there is no difference in the efficiency of enhanced and other active strategies. We captured this assumption by equalizing the information ratios for the two active strategies and for the enhanced strategy, even though one would expect enhanced strategies to have higher information ratios.
Using these assumptions, we built a simple core-satellite portfolio to serve as our base case, allocating 50% to indexed investments and 25% each to standard active and highly active funds, with no allocation to enhanced. The resulting portfolio is expected to outperform the S&P 500 benchmark by 86 basis points, with a tracking error of 2.05%, for an information ratio of 0.42 (see Table).