The active passive framework really tries to help investors to make what we say the implicit explicit. So really to take conscious of what their implicit active exposures might be in their current portfolio and act accordingly. That really means that they have to assess what their level of active risk tolerance is. Let me take an example. An investor might be a 20/80 investor, meaning 20% equities and 80% bonds, but taking that exposures mostly through active portfolio managers, so having a large portion of their portfolio invested in what we call active risk. On the other hand, you might have another investor that is a 60/40 investor, so 60% equity and 40% bonds, but the total level of active risk of that portfolio being very, very small because they mostly take that exposure through trackers or passive funds.

So the first investor, just because of the exposures that they have in active portfolio managers, the total level of risk may actually be higher than the second portfolio, the second investor, even though their equity exposure is lower. So the framework really tells you that in order to consider more realistically what your optimal asset allocation is, you should consider active risk into the portfolio and your risk tolerance associated with that.

And again, the risk return tradeoff is that, so the alpha potential, along with the beta exposure, so the expected return from the asset class and sub asset classes, but also the total level of risk that you would have in the portfolio, which is a combination of the passive risk and the additional active risk that comes with that, and of course the cost associated with those exposures.

The active passive framework at Vanguard really identifies four key aspects that investors should be considering in order to blend active with passive in their portfolios. As we mentioned, the first one is the expected alpha, so what is the element of the amount of alpha and excess performance that an active manager would bring in the portfolio? The second one is the associated level of risk with that active exposure, which very often is proxied by the tracking error. The third one is the level of active risk tolerance that investors would be willing to take into their portfolio. And last but not least, of course, the associated cost with the active exposure. And that really fits into the broader structure and framework for identifying the optimal blend between asset class and sub asset classes and more generally speaking, the holistic approach to financial planning. I would say that from an investor’s perspective, in terms of identifying the best active managers, they really should be focusing on two things. The first one is the Alpha. What is the level of outperformance that over the long term an investor would expect from a specific active manager to deliver for a specific asset class?

The second one is, of course the tracking error associated with that, and that can mean many things. It is of course the tracking error as a proxy, but can also mean any tilt that an active manager would have and could have, in factors for instance, that would also make the strategy deviating from the benchmark, but some of these factors might come with risk premia, some of them might be behavioural premia.

So also the factor’s exposures that a specific portfolio manager could bring should be taking into account in the active passive blend. Once these two elements, two or three elements are identified, then active risk tolerance can be taken into account along with cost and following the framework and the optimisation tool that we have at Vanguard then using those in order to come up with the perfect mix and blend between active passive and within passive asset class and sub asset classes.