Insights for evaluating active management
In principle, an investor selects an asset allocation policy that reflects a trade-off between two extreme goals: to seek as high a return as possible, and to take as little risk as possible. The trade-off compromises both goals, to an extent that reflects the investor’s risk tolerance. Once that choice is made, the investor can then implement the selected policy passively, by buying portfolios that match market indices in each asset class (or the nearest equivalent to a market index, for an asset class without an investable index). This is typically the most inexpensive way to secure market exposure to each asset class.
But most investors choose active rather than passive management. They hire one or more managers who take positions (which I’ll call “bets”) against their passive benchmarks. Since this is more expensive, the investor’s implicit hope must be that the aggregate active portfolio will beat the passive implementation of the policy, by a sufficient margin to compensate both for the added cost and for the risk of failure. The margin is usually called the excess return or the value added.