Optimizing Manager Structure and Budgeting Manager Risk

Abstract

Selecting active managers and structuring their use has historically been more art than science. The authors explain why a manger structure can and should be approached as a problem of portfolio construction, a view that brings a whole set of tools to bear on the problem. This approach suggests optimizing to maximize expected active returns while controlling active risks. For a given risk budget, there is a single combination of the candidate managers who will best maximize the risk–adjusted expected active return of the portfolio. An optimized approach will also solve the active–passive or core–satellite allocation problem, a perennial area of indecision. The passive or core managers will naturally be held by the optimizer in inverse proportion to the active risk budget. This approach can be easily modified to process off–benchmark managers and to incorporate an optimal completion solution as part of the overall structure. This is a practical an robust manger structure solution appropriate to any investor using multiple managers or interested in the optimal active–passive mix.