Integrating Active Return into Asset Allocation Modeling

Long-term asset class forecasts, or capital market assumptions, typically focus on the future performance of broad markets. However, most investors employ some combination of passive and active management in their portfolios. And active management is most often pursued with the expectation that returns will be different than that of the broad market (specifically, that “active return” will be achieved above and beyond the market return). If capital market assumptions are typically comprised of market forecasts, but investors tend to build portfolios with the expectation of market return plus active return, how might investors estimate the expected behavior of active management (active return) in their asset allocation work?

In this Topic of Interest we look at this question from multiple angles. First, there is not a single universal level of active return that all investors should assume. The active return that an investor might expect will depend on their specific portfolio exposures and the level of tracking error that they incur, which is driven by the investor’s individualized approach to active management. Due to this fact, we believe it is inappropriate to assume a “standard” active return in Capital Market Assumptions for use by all investors. Second, there are many ways to arrive at an active return forecast, ranging from theoretical (example: assumed information ratio) to track-record based (example: assumption that a product’s future active return will equal its historical active return), and ranging from simple to complex. We will touch on these methods and outline the merits of each. Last, we believe humility plays an important role in this process, as it is possible that aspirational active return may often exceed that which is realized. It is human tendency to have overconfidence in our abilities. Investors might consider whether conservative estimates or more aspirational estimates are appropriate for their situation.