Adaptivv - Active vs. Passive
Market risk measurement and control, a comparison of passive with active risk management
“The essence of investment management is the management of risks, not the management of returns.”
(Benjamin Graham)
Editorial
As a spin-off of ETH Zurich, Adaptivv Financial Technologies AG has been working intensively since 2016 on issues related to the efficient risk management of financial portfolios. In this context, we often encounter the common “active vs. passive” debate around the advantages and disadvantages of active versus passive investment management (or tactical vs. strategic allocation).
As is often the case, the truth is found in the middle. A good combination of strategic and tactical allocation usually delivers the best results in terms of limiting maximum losses and achieving optimal risk compensation. This episode of Active vs. Passive is about whether active management of the equity allocation in a portfolio can generate added value.
I wish you an exciting read.
About Adaptivv Financial Technologies
Adaptivv Financial Technologies AG was created in 2016 as a spin-off from the Swiss Federal Institute of Technology Zurich (ETH) and is now considered an established and competent partner when it comes to Drawdown Management. Since 2016 we successfully use the Bayesian Change Point method to identify regime changes in the traditional as well as in the digital market.
The Adaptivv Sensor has been developed at ETH Zurich over a period of more than 10 years. The Adaptivv Sensor measures the stability of the market real-time and provides a clear, actionable output to adapt to current market conditions and risks. As a result, we can protect your portfolio from severe drawdowns and increase risk-adjusted returns. For 6 years, Private Banks, Family Offices and Swiss Pension Funds trust our technology.
Introduction
Most investors would prefer a portfolio that (1.) regularly outperforms the market, and (2.) loses as little value as possible during times of crisis or even (3.) realizes gains in negative phases.
(1.): With a purely passive allocation (e.g. 50% bonds & 50% stocks) an outperformance is hardly possible. A passive portfolio usually delivers a return that is below the stock market in the long run. In this respect, a passive allocation always represents a compromise between risk limitation and achievable return in the long run.
(2.): A passive allocation below 100% reduces maximum losses roughly in a linear proportion to the decreasing allocation to the risky assets. Unfortunately, during market crises the desired protective mechanism of diversification across other asset classes has only a limited effect, as correlations increase significantly in such negative phases and most asset classes collectively lose value.
(3.): Profits can only be realized in negative market phases with inverted (short) positions, but this requires not only good tactical management but also the use of derivatives, which is not possible in every investment context. In this respect, this is also not a topic for this issue.
Is active investment management worthwhile in principle?
To answer this question, in this issue of Active vs. Passive we will analyze active management of the equity allocation, although this can be implemented similarly with other asset classes in a portfolio context.
For this purpose, we use a global equity portfolio subsumed into an index from different industry sectors, where the allocation ratios of the respective industrial sectors are actively managed. The funds not allocated to industrial sectors are invested in liquid money market funds. The active index (Adaptivv Downside Control World Index) shown in the following uses the full range of equity allocation from 0%-100%. In practice, this can be implemented efficiently either via an allocation to liquid spot market instruments or - for larger portfolios - via derivative overlays.
1. Passive Investment Management
The 50/50 Portfolio: The first question to ask is which realistic expectations in terms of performance and risk parameters we can have for a passive portfolio. For this purpose, we compare global equity (100% investment) with a 50%/50% equity/money market (cash) investment. This avoids distortions of the analysis due to fluctuating bond returns.
Performance
GLOB_EQTY_50.DR GLOB_EQTY.DR
Annualized Return 0.03759944 0.06952015Risk
GLOB_EQTY_50.DR GLOB_EQTY.DR
Worst Drawdown 0.3088112 0.5372069
GLOB_EQTY_50.DR GLOB_EQTY.DR
Annualized Standard Deviation 0.07538961 0.1510955 GLOB_EQTY_50.DR GLOB_EQTY.DR
Annualized Sharpe Ratio (Rf=0%) 0.4987351 0.4601072Results Discussion
The 50/50 portfolio achieves about half of the return of the 100% allocation. In combination with approx. halving the standard deviation there is a largely linear relationship between reduction of risk and return, the risk compensation (Sharpe) is therefore basically unchanged.
The maximum drawdown of the 50/50 portfolio is slightly higher than 50% of the full allocation, this is a typical effect of the inherent rebalancing delay.
So, to summarize: A 50/50 portfolio provides significant benefits in terms of risk reduction, however at relatively high costs in terms of reduced performance.
2. Active Investment Management
Active (tactical) management can be done on single equity or on index level. The advantage of working with indices is the lower noise levels (erratic moves of single stocks are evened out on portfolio/index level). This architecture can also be implemented for multi-asset portfolios in a comparable form.
Risk Management Architecture
We have chosen a dynamic allocation between different industry sectors, as it allows to adjust the allocation to the different dynamics of these sectors.
Performance
As a realistic active benchmark we use the Adaptivv Downside Control World Index (ISIN: DE000A3EEG05, Bloomberg: ADAPTW. Refinitiv: .ADAPTW) which comprises eleven exchange traded ETFs with allocations to: Cyclical Consumer Goods, Communications Services, Consumer Discretionary, Energy, Financials, Healthcare, Industrials, Information Technology, Materials, Real Estate and Utilities and an exchange-traded money market fund (cash instrument). In this index, using the respective sector stabilities, the sector weights are rebalanced on a weekly basis.
For more index detail please visit the LIXX Index Page.
GLOB_EQTY_50.DR GLOB_EQTY.DR ADAPTW.DR
Annualized Return 0.03759944 0.06952015 0.0784039Risk
GLOB_EQTY_50.DR GLOB_EQTY.DR ADAPTW.DR
Worst Drawdown 0.3088112 0.5372069 0.190947
GLOB_EQTY_50.DR GLOB_EQTY.DR ADAPTW.DR
Annualized Standard Deviation 0.07538961 0.1510955 0.1015174Rolling Standard Deviation
GLOB_EQTY_50.DR GLOB_EQTY.DR ADAPTW.DR
Annualized Sharpe Ratio (Rf=0%) 0.4987351 0.4601072 0.7723196Correlation Analysis
Results Discussion
The benefits of an active risk management are most visible in the long-term perspective. By protecting against major drawdowns during large market crises, the Adaptivv Downside Control World Index shows a much faster recovery after severe market crises and outperforms even the 100% equity market allocation with lower volatility overall.
Due to the asymmetry between losses and required recovery (a 50% loss requires 100% performance to just recover), capital protection is probably the most relevant function of an active asset management. E.g, in 2008 a 100% exposure would result in a drawdown of more than -50%, whereas the active controlled exposure peaked at approx. -15%.
As the volatility of the actively hedged version is significantly lower it allows to increase the equity share in a portfolio from a risk parity perspective, thus potentially generating overall higher returns.
Disclaimer & Contact
This paper contains theoretical use-cases, which are intended for finance professionals. While the publisher and the authors have used their best efforts in preparing this publication, they make no representations or warranties with respect to the accuracy or completeness of the contents of this publication and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials.
Even though some instruments show more or less favorable properties, no explicit investment advice is made nor suggested. The assessment contained herein may not be suitable for your situation. You should consult with an investment professional where appropriate. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages based on this publication.
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