equities | june 28, 2024
How an investment strategy can blend the best of active and passive
A research-enhanced strategy can help clients get more from their portfolio’s core.
Key Insights
Clients worried about overly relying on the market’s continued strength may want to consider a strategy that aims to blend the best of active and passive investing.
A product that seeks a market‑plus return with market‑like risk could add value as an alternative or as a complement to typical passive or active solutions.
An analyst‑driven approach, when it’s well executed, has the potential to generate strong, risk‑efficient returns through the market’s ups and downs.
Tamzin Manning
Equity Portfolio Specialist
The appeal of passive investment solutions offering exposure to broad equity indexes is easy to understand. Low fees and a strong stock market have made for a compelling proposition.
For clients concerned about relying too much on the broader market’s continued strength to meet their longer‑term objectives, a middle path that combines the advantages of active and passive could be appealing.
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Seeking the best of both worlds
Passive investment strategies that track indexes such as the S&P 500 or the MSCI All Country World are common portfolio building blocks.
Consider the popular core/satellite approach to portfolio construction.
Here, the core usually consists of passive solutions that offer a market-like return.
These core investments aim to balance satellite strategies that take more active risk in the pursuit of stronger outperformance.
Shifting to traditional actively managed products isn’t necessarily an option for clients seeking to diversify their portfolio’s core. That’s especially true if they have a strict risk budget.
By design, active strategies tend to exhibit higher levels of tracking error, or variability in their performance relative to the benchmark.
Funds with higher tracking error can outperform, but the dispersion in results historically has been wider in this group (Figure 1). Picking the right manager is critical.
An active‑enhanced index strategy could add meaningful value as an alternative or as a complement to typical passive or active solutions.
The value proposition is simple: the prospect of a market‑plus return with market‑like risk. However, consistently delivering on these goals has been difficult for the asset management industry.
We believe that an analyst‑driven solution, when it’s thoughtfully designed and well executed, has the potential to generate strong, risk‑efficient returns through the market’s ups and downs.
...a middle path that combines the advantages of active and passive could be appealing. 
Wider dispersion in outcomes for U.S. large-cap equity funds with higher tracking error
(Fig. 1) Average annualized excess returns, after fees, and tracking error vs. the S&P 500 Index
March 31, 2014, to March 31, 2024.
Past performance is not a reliable indicator of future performance.
Source: Morningstar Direct. Data analysis by T. Rowe Price. See Additional Disclosures.
The exhibit comprises U.S. large-cap equity funds that had at least USD 250 million in assets under management as of March 31, 2024, and use the S&P 500 Index as their primary benchmark. The exhibit omits a small number of outlier data points with tracking errors higher than the top range. Here, tracking error measures, in basis points, the volatility in a fund’s returns relative to its benchmark. One basis point is 0.01 percentage point. Funds with higher levels of tracking error have exhibited higher levels of variability in their performance relative to the benchmark; funds with lower levels of tracking error have exhibited less divergence in performance versus the benchmark. Excess return is the difference between a fund’s total return (including reinvested dividends) and the total return generated by the S&P 500 Index (including gross dividends reinvested). The funds’ total returns are based on net asset values and, thus, are net of management fees and other costs.
Fundamental research as a source of potential edge
The design and implementation of active‑enhanced index strategies vary. Some rely on risk controls and stock picking. Others look to enhance returns through derivatives or by bundling fixed income strategies on top of exposure to the broader equity market.
Regardless of the approach, two principles are usually in play:
Identifying a source of edge that creates the potential for excess returns across different market environments; and
Isolating this competitive advantage by implementing strict portfolio construction rules that aim to approximate the risk exposures of the broader market.
Of course, markets are dynamic and highly competitive. Many sources of investment edge erode, unless they, too, change and adjust.
The potential advantages that come from rigorous fundamental research could be more durable because analysts focus on how a company’s prospects and risk/reward profile may evolve over time.
For this reason, a risk‑controlled strategy that seeks to isolate the power of individual analysts’ stock‑picking skills may have the ability to outperform in a variety of environments.
A large active manager may have a leg up because it can support a global team of experienced research analysts to offer both breadth of coverage and depth of knowledge.
With the resources to pursue their curiosity and creativity, these experts should be well positioned to develop differentiated investment insights.
Building an analyst‑driven strategy in pursuit of risk‑efficient returns
Here’s one way a strategy can offer the potential benefits of active stock picking while maintaining a similar look and feel to popular market benchmarks.
Analyst‑driven stock picking: Capital is spread across an extensive team of seasoned analysts. Each receives an allocation in proportion to the weighting of his or her coverage universe in the benchmark. They do not need to own every company in the index. Instead, each analyst seeks to allocate more capital to the stocks whose business fundamentals look attractive and to underweight or avoid names whose prospects appear less favorable. The portfolio also has the flexibility to hold a small proportion of stocks outside the index.
Risk controls: Deviations from the benchmark are governed by strict constraints on active weightings at the sector, industry, and holding levels. An oversight team tracks a battery of factor exposures—for example, momentum, business quality, growth, or value—and works with the analysts to rebalance the portfolio regularly. These efforts seek to ensure that the strategy isn’t taking any unforeseen risks relative to its benchmark.
Taking a multi‑contributor approach captures a diversity of viewpoints and investing styles while limiting the key‑man risk associated with single‑manager strategies. Relying on analysts to select stocks in the sectors and industries they know so well also provides a layer of risk management.
When implemented effectively, this process should result in a risk-controlled portfolio that creates a stage for the analysts’ stock selections to drive relative performance.
...a risk-controlled portfolio...creates a stage for the analysts’ stock selections to drive relative performance. Combining the advantages of active and passive investing
Popular indexes such as the S&P 500 and the MSCI All Country World were created to measure the performance of the broader market. Despite their strong performance over the past 10 years, they were not designed as investment portfolios.
Putting seasoned analysts directly in charge of stock selection for their area of expertise offers exposure to the potentially return‑enhancing benefits of active management:
Exploiting dislocations: Whether it’s a possible peak or trough in the market, a sector, or a stock, a deep understanding of individual companies and their growth prospects can give analysts the courage of conviction to trim or add to a position when uncertainty is high.
Taking advantage of heightened dispersion: Focusing on fundamentals can also help when the differences in stock performance are especially high in a sector or industry. Consider, for example, the divergence in returns generated by companies that are perceived as benefiting from investments in advanced artificial intelligence.
Looking forward, not backward: Analysts may be able to start a position before the company joins the benchmark or avoid names that are at risk of being removed. In these instances, the resulting investment inflows or outflows may boost or inhibit a stock’s near‑term performance.
At the same time, appropriate controls mean that an actively managed product that’s designed in this way can offer a similar risk profile to passive portfolios that track a broader market index:
Diversification across sectors, industries, and individual companies is part of the appeal.
Market‑like regional and sector weights, as well as factor exposures such as momentum or style (growth versus value), can help to blunt the risk posed by sharp shifts in market leadership.
This approach should yield a neutral portfolio that doesn’t rely on a particular subsection of the market to generate excess returns. In other words, the potential for outperformance is spread across a diversity of sectors, industries, and individual companies.
These qualities may strike clients as compelling after the roller coaster ride of the past several years and the extraordinarily narrow market of 2023, when a handful of mega‑caps drove the bulk of the upside.
Even modestly higher returns potentially can improve retirement outcomes
(Fig. 2) Hypothetical impact of potential excess returns on portfolio growth
| Demographic Assumptions | Scenario Assumptions | Baseline | +25 BPS | +50 BPS | ||
|---|---|---|---|---|---|---|
| Starting Balance | USD 0 | Returns Before 65 | 7.00% | 7.25% | 7.50% | |
| Starting Age |
25 | Returns After 65 | 5.00% | 5.25% | 5.50% | |
| Starting Salary | USD 30,000 | Account Balance at 65 | USD 845,930 | USD 897,859 | USD 953,452 | |
| Annual Salary Growth Rate | 3% | Withdrawal (% of Ending Salary) | 50% | 50% | 50% | |
| Annual Contribution Rate | 9% | Annual Withdrawal Amount | USD 48,931 | USD 48,931 | USD 48,931 | |
| Retirement Age | 65 | Withdrawal Increase | 3% | 3% | 3% | |
| Ending Salary | USD 97,861 |
The results shown above are hypothetical, do not reflect actual investment results, and are not a guarantee of future results. Hypothetical results were developed with the benefit of hindsight and have inherent limitations. Hypothetical results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Results do not include the impact of fees, expenses, or taxes. Results have been adjusted to reflect the reinvestment of dividend and capital gains. Actual returns may differ significantly from the results shown. The demographic assumptions, returns, and ending balances are shown for illustrative purposes only and are not intended to provide any assurance or promise of actual returns and outcomes.
Source: T. Rowe Price.
A little bit can go a long way
Aiming to approximate the risk characteristics of an index might limit the magnitude of a portfolio's potential excess returns over shorter time frames. However, these controls also reduce the risk that it will underperform the benchmark by a wide margin.
In a more subdued long‑term environment for equity returns, even a modest excess return from active management could make a meaningful difference in retirement outcomes (Figure 2).
Our analysis, for example, suggests that an additional 25 basis points in return over 40 years of savings could result in an additional two years of retirement spending. Increasing the excess return to 50 basis points could add five additional years of spending.
Bottom line: An analyst‑driven strategy that combines the best of active and passive investing has the potential to make a real difference for clients over the long term. Evaluating the people and process is critical to identifying strategies with the potential to deliver above‑market returns with market‑like risk.
Additional Disclosures
The S&P 500 is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”) and has been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). T. Rowe Price is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500.
©2024 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of June 2024 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. All charts and tables are shown for illustrative purposes only.
T. Rowe Price Investment Services, Inc., distributor, and T. Rowe Price Associates, Inc., investment adviser.
202406‑3662470
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