The objective of this paper is to describe how an investor can define a target return, split between that of Strategic Asset Allocation (SAA) and excess return derived from active portfolio management. The balance between these two major sources of return clearly depends on the investor’s definition of what is relevant to Strategic Allocation and to active management. Our observation here is that the impact of SAA rebalancing and structural tilting towards certain assets and factors are generally included within strategic return, whereas active management encompasses the contributions of Tactical Asset Allocation (TAA) and of manager or security selection.
In order to quantify the excess return target for their portfolio, investors tend to rely on information ratio assumptions, and these depend on the investor’s belief in the added value of active management and on the structure of their portfolio. Our analysis shows that active managers have generally performed favourably within the Global Fixed Income and Global Equity asset classes, justifying positive information ratio assumptions there. The size of the investor’s assets relative to those of the underlying markets is also a meaningful factor, especially for large institutions holding a significant share of their domestic markets. This leads us to discuss the issue of capacity and, as an illustration, we try to quantify the relationship between the size of assets under management and the target tracking error of an active portfolio to be invested in international equities.
We then describe the most common practice, following interviews with a sample of major institutional investors. We observe in particular that excess return targets tend to have a “motivational” purpose and are designed to instil ambition in portfolio managers. There is a rather wide divergence around an estimated 45bp average target, which is determined either top-down, based on a mix of experience and academic background, or using a bottom-up approach, based on the aggregation of the expected contributions of the different components of the portfolio. Our observation is also that excess return target seems to be negatively correlated with asset size, as the largest global investors make more extensive use of passive management in particular, and that it is positively correlated with the total return target for the portfolio, with a median ratio of about 10% between both.
Based on these observations, we propose two quantitative methods to help investors set the excess return target for their portfolio. The first one is derived from the following constraint: ensuring that the negative outcome of active management in a worst-case scenario over a long-term horizon (say 10 years) does not represent more than one year of the investor’s strategic expected return. The second approach derives the implied excess return consistent with Markowitz optimality conditions based on observing the tracking error of active management and its correlation with the total portfolio return.
Combining the conclusions of academic studies with peers’ observations as well as with the quantifications that we propose, we believe investors are equipped with a diversified toolbox to help them set the target excess return for their portfolio of assets.