A Spectrum Approach
to Active Risk Budgeting
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
Rethinking the barbell.
Andrew Alford, Robert Jones, and Kurt Winkelmann
ANDREW ALFORD is a vice
president and research direc-
tor, Quantitative Equity Man-
agement, at Goldman Sachs
Asset Management in New
York (NY 10005).
andrew.alford@gs.com
ROBERT JONES is a managing
director and CIO, Quantita-
tive Equity Management, at
Goldman Sachs Asset
Management.
bob.jones@gs.com
KURT WINKELMANN is a man-
aging director and co-head,
Global Investment Strategies,
at Goldman Sachs Asset
Management.
kurt.winkelmann@gs.com
FALL 2003
ere’s a problem most institutional investors
H face. What is the best blend of active and pas-
sive managers in their equity portfolios?
Some investors implement fully passive port-
folios. Others use the passive alternative to dilute the risk
in their active program by barbelling, i.e., hiring a roster
of traditional active managers at one end of the risk spec-
trum, and mixing in index funds at the other, to hit an
active risk target that lies somewhere in the middle.
We believe investors who follow a barbell strategy
are missing a valuable opportunity to put their passive
exposure to work. This lost opportunity is analogous to
the opportunity that investors miss when they include
cash in their strategic asset allocations. In our view,
investors can improve the expected risk-adjusted perfor-
mance of their active portfolios by substituting structured
equity managers for their passive positions.
It is now commonplace to categorize active man-
agers by their level of active risk; structured managers usu-
ally take less active risk than traditional managers.1 In our
view, most investors should allocate risk across the entire
active risk spectrum—that is, most equity programs
should entail a blend of passive, structured, and traditional
equity management. We call this approach the spectrum
strategy.
Why are investors better off using a spectrum strat-
egy rather than a barbell? We believe there are four prin-
cipal reasons:
THE JOURNAL OF PORTFOLIO MANAGEMENT 49
 1. On average, the historical risk-adjusted perfor-
mance of structured managers has been better than
the performance of traditional active managers.
2. We believe these performance differences are the
result of inherent methodological differences.
3. To the extent that active management can add
value, investors with significant passive exposures
are effectively creating drag on their overall port-
folio performance.
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
4. Because the spectrum strategy diversifies the
active risk budget, we believe investors can
achieve a higher return per unit of active risk by
including structured equity products in their
portfolios (i.e., process diversification).
We first examine the historical track records of struc-
tured and traditional active equity managers. Then we
explore the methodological differences that drive these per-
formance differences. Finally, we show how investors can
apply these findings, together with active risk budgeting
techniques, to their large-cap U.S. equity portfolios.
EVALUATING STRUCTURED
AND TRADITIONAL MANAGERS
Many investors implement their long-term asset allo-
cations to large-cap U.S. equities by combining passive and
traditional active management. Because we believe investors
should also include structured equity in the mix, we start
with a review of the historical risk and performance char-
acteristics of traditional and structured managers.
Our sample of structured and traditional managers
is taken from the Plan Sponsor Network (PSN) database
of institutional manager returns.2 We first construct quar-
terly time series returns for 1,052 large-cap U.S. equity
managers over the period 1989 through 2001. We then
drop all managers with fewer than 24 quarters of perfor-
mance history.
We use historical tracking errors to segregate man-
agers, classifying lower-tracking error managers as struc-
tured, and higher-tracking error managers as traditional.
Market conventions place structured equity managers in a
target tracking error range of 100 to 250 basis points (bp).
Given that realized (or historical) tracking errors could
exceed targets, we identify structured managers as those
with realized tracking error levels between 100 and 300 bp.
Market convention also suggests traditional managers
have tracking error targets—to the extent they are bench-
mark-sensitive and have tracking error targets—in excess
50 A SPECTRUM APPROACH TO ACTIVE RISK BUDGETING
of 600 bp. Of course, realized tracking error levels can also
undershoot targets. Hence, we define traditional managers
as those with realized tracking errors in excess of 500 bp,
but below 1,500 bp. (The upper bound is meant to
exclude managers who may have significant holdings in
other asset classes, such as small-cap equities, interna-
tional equities, or bonds.)
We judge it too difficult to classify managers with
realized tracking errors between 300 and 500 bp, who are
thus eliminated from further analysis. The results are not
sensitive to exclusion of these managers.
Classification using realized tracking errors is likely
to result in misidentification of some managers. A man-
ager could intentionally switch between low- and high-
tracking error regimes as part of active decision-making.
A traditional manager with unusually good perfor-
mance, for example, might decide to lock in this good
performance by reducing risk. If the change in risk is con-
siderable, and if the manager spends too little time in the
high-tracking error regime, we could mistakenly classify
the manager as structured. Similarly, a structured manager
with a low target tracking error might just happen to have
a high realized tracking error if risk increases dramatically.
In this case we might incorrectly put the manager in the
traditional category.
Unfortunately, we do not have enough information
to detect regime-switching behavior or to know whether
a particular manager has underestimated (or overesti-
mated risk). Any resulting misclassification of managers
adds noise to the analysis, which weakens the power of
the tests and makes it more difficult to differentiate struc-
tured and traditional managers. Our strong results lead us
to believe that misclassification of managers is not a seri-
ous problem, and that our database is sufficiently rich both
to classify managers and to produce historical differences
that merit discussion.
Exhibit 1 shows the summary performance and risk
characteristics for each group of managers, including the
historical average, median, and top-quartile and bottom-
quartile figures for four performance and risk character-
istics: active return, tracking error, information ratio, and
pairwise correlation. We calculate the quartile cutoff
points independently for each risk or performance char-
acteristic. For example, the structured manager with the
median active return may not be the same as the manager
with the median tracking error.
The performance and risk figures in Exhibit 1 indi-
cate why selection among different types of managers is
such a challenge for institutional investors. Let’s look at
FALL 2003
 EXHIBIT 1 parison of management styles. To complete the picture,
Performance Relative to S&P 500 1989–2001 we should also look at risk. Given that we intentionally
classify managers using realized tracking errors, one should
Active Return Tracking Error Information Pairwise not be surprised that the tracking errors for structured
(bp) (bp) Ratio Correlation
managers are lower than those for traditional managers.
Structured Managers (64 Managers) For example, the median tracking errors are 221 and
Average 43 209 0.26 0.08 769 bp, respectively, for the structured and traditional
Median 52 221 0.28 0.08 managers. At the extremes, the top-quartile structured
manager has had a historical tracking error of 266 bp, while
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.

Top Quartile 92 266 0.44 0.27

It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

the bottom-quartile manager has a realized tracking error

Bottom Quartile -4 147 -0.02
Traditional Managers (561 Managers)
Average 53 821 0.05
Median 53 769 0.07
Top Quartile 201 971 0.27
Bottom Quartile -120 619 -0.16
Past performance is not indicative of future results, which may vary.
Structured managers have a realized tracking error of 1% to 3%, and tradi-
tional managers have a realized tracking error of 5% to 15%, where tracking
errors are measured using all data available for each manager.
the performance record first, and then consider differences
in risk.
Historically, the average active return is quite sim-
ilar for structured and traditional managers. On average,
traditional managers have had an active return of 53 bp,
while the active return for structured managers was slightly
lower at 43 bp. The median active returns are even closer,
at 52 bp for structured managers and 53 bp for traditional
managers—despite significantly lower risk for the struc-
tured managers. Given that traditional managers usually
charge higher fees, and our results are gross of fees, it would
be hard to argue that, on average, traditional managers have
provided higher risk-adjusted active returns net of fees.
More interesting, though, is the dispersion in active
returns. The top-quartile structured manager has had an
active return of 92 bp, while the bottom-quartile struc-
tured manager has an active return of –4 bp. Consistent
with the differences in risk-taking, the top-quartile tra-
ditional manager has had an active return of 201 bp,
while the bottom-quartile manager underperformed the
benchmark by 120 bp. Thus, the historical performance
record seems to indicate that, on average, structured and
traditional managers outperformed by roughly the same
amount. Yet, manager selection is much more important
for traditional managers because the spread in results is
much wider.
Historical returns alone provide an incomplete com-
-0.10
of 147 bp. The top-quartile traditional manager has had
a tracking error of 971 bp, and the bottom-quartile man-
0.13 ager a tracking error of 619 bp. Thus, in keeping with the
0.14 way we define our sample, investors were likely to see
0.36
higher realized active risk levels from their traditional
managers than from their structured managers.
-0.10
A useful way to assess the risk/reward trade-off is
through the information ratio, defined as active return per
unit of active risk (or active return divided by tracking
error). The information ratios in Exhibit 1 are perhaps the
most interesting, as they suggest significant differences
between these active management approaches. The historical
information ratios for structured managers are higher than those
for traditional managers at all skill levels. For example, the
median structured manager has had an information ratio
of 0.28, compared to 0.07 for the median traditional
manager.3
The dispersion of information ratios is also more
pronounced for traditional managers. The top-quartile
information ratio for traditional managers is almost four
times the median. For structured managers, the top-quar-
tile information ratio is only 57% higher than the median.
Taken together, these figures suggest that structured man-
agers added more active return per unit of active risk, and,
further, that manager selection is incredibly important in
developing a portfolio of traditional managers.
For the most part, the pairwise correlations between
active returns show no difference by active management
style. The median correlation between structured man-
agers is 0.08, while the median correlation between tra-
ditional managers is 0.14. These figures are reassuring, as
they suggest that, within each management style, man-
agers are not assuming the same active risks. In other
words, managers seem to be expressing different views or
using different portfolio construction techniques (or both)
in their active decisions.
The figures in Exhibit 1 provide evidence on the ex
post performance of individual managers. Given this evi-
dence, investors may wonder whether it makes sense to

FALL 2003 THE JOURNAL OF PORTFOLIO MANAGEMENT 51

 EXHIBIT 2
Performance Relative to S&P 500 1992-2001

Two Managers Four Managers

Active Tracking Active Tracking
Return Error Information Return Error Information
(bp) (bp) Ratio (bp) (bp) Ratio
Structured Managers
Bottom Quartile -54 178 -0.26 -29 141 -0.21
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

Median 61 234 0.21 49 176 0.24

Top Quartile 155 297 0.66 123 217 0.63
Traditional Managers
Bottom Quartile -247 430 -0.51 -180 366 -0.46
Median -23 572 -0.09 -14 461 -0.12
Top Quartile 240 784 0.37 170 589 0.28

Past performance is not indicative of future results, which may vary.

Managers are classified as structured or traditional at the end of each year based on their realized tracking error over the previous 12 quarters, where structured
managers have a realized tracking error of 1% to 3%, and traditional managers have a realized tracking error of 5% to 15%. Managers remain structured or traditional
for the subsequent 12 quarters.

include traditional managers in the mix at all. The rea-
son for including traditional managers is straightforward:
Most institutional investors hold portfolios of managers.
Thus, the choice is not between a structured manager and
a traditional manager, but between alternative portfolios
of managers. What happens if we view the historical
experience in this light?
To assess the differences between structured and
traditional strategies at the portfolio level, we create com-
posites of structured and traditional active managers for
the period between 1992 and 2001. As with our earlier
analysis, we distinguish between the different manager
types using realized tracking errors—but this time, to
ensure we have an investable strategy, we use the prior
three years to classify managers for the next three-year
holding period. We continue to measure performance
against the S&P 500.
For each three-year time period, we form two
groups: structured equity managers (1%–3% tracking
error) and traditional active managers (5%–15% tracking
error). Within each group, we next create 100 randomly
selected composite portfolios of two and four managers
(equally weighted), and then calculate average buy-and-
hold returns for each subsequent three-year period.
Exhibit 2 shows the active returns, tracking errors,
and information ratios for various cutoff points in the sam-
ple. For example, the top quartile represents the 25th best
portfolio of managers in the sample according to the indi-
cated statistic. Thus, we can think of these breakpoints as
representing an investor’s skill level in developing a port-
folio of managers.
The results in Exhibit 2 are consistent with those in
Exhibit 1. Compared to portfolios of traditional man-
agers, the portfolios of structured managers have higher
median active returns (with less risk), and higher infor-
mation ratios at all levels. For example, for the results with
four managers, the median information ratio for portfo-
lios of structured managers is 0.24 versus –0.12 for
portfolios of traditional managers. Not surprisingly, the
portfolios of structured managers also have lower average
tracking errors and less dispersion in tracking errors and
active returns. Thus, we see again that skilled manager
selection is much more important when developing a port-
folio of traditional managers.4
The results in Exhibits 1 and 2 raise an interesting
question. Why did structured managers perform so well
(on a risk-adjusted basis) compared to their traditional
counterparts? To answer this question, we must dig more
deeply into the underlying investment methodologies of
structured and traditional managers.

52 A SPECTRUM APPROACH TO ACTIVE RISK BUDGETING FALL 2003

 STRUCTURED AND TRADITIONAL
APPROACHES TO INVESTING
The primary difference between structured and tra-
ditional managers lies in their approach to risk and bench-
marks. Structured managers are highly benchmark-
sensitive and tend to target relatively low levels of track-
ing error. Structured managers usually attempt to hit their
lower targets by relying on a relatively large number of small
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
active deviations (i.e., overweights and underweights).
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
Traditional active managers by contrast usually tar-
get high ex ante active returns. Although most do not
explicitly target tracking error, their quest for active
returns often results in high ex post active risk. This is
because traditional managers usually restrict their active
decision-making to a small number of relatively large
positions. The difference in the size of active positions is
key to understanding the risk and performance differences
between traditional and structured managers.
One major consequence is that traditional man-
agers are less able to achieve symmetry between their
bullish and bearish views. Why? Because of the no-short
constraint that most institutional investors face.
Managers can generally overweight a stock by as
much as they’d like, but they can underweight a stock only
up to its weight in the benchmark. Since most tradi-
tional managers want to implement relatively large active
deviations, this constraint is often binding. While they can
theoretically overweight their favorite names by as much
as they’d like, they can fully underweight their least favorite
names in only a few cases (that is, when the benchmark
weight is large enough to accommodate the desired under-
weighting). As a result, because overweights and under-
weights must sum to zero, the no-short constraint
effectively hinders a manager’s ability to express bullish
views as well. Consequently, the no-short constraint, and
related lack of symmetry, will reduce a traditional man-
ager’s potential information ratio.
Structured managers, by contrast, can take greater
advantage of both their bullish and bearish views. They
are able to more fully exploit their views because of their
relatively low tracking error targets and their propensity
to take a large number of relatively small active deviations.
Thus, the no-short constraint, while still binding, is less
binding because desired underweights exceed benchmark
weights less often.
A second difference between structured and tradi-
tional managers is the emphasis on risk management.
With tight tracking error targets, structured managers
FALL 2003
spend a great deal of time and effort managing risk and
eliminating unintended bets—just as a household on a
tight budget will be more frugal. Traditional managers feel
less constrained by tracking error concerns, and spend
commensurately less time on risk management. As a
result, unintended and uncompensated risks can creep into
their portfolios.
For example, many traditional managers roughly
equal-weight the names in their portfolios. This can pro-
duce large overweights in small-cap names and smaller
overweights (or even underweights) in large-cap names.
The resulting small-cap bias adds uncompensated risk to
the portfolio, because the overweight in smaller names is
driven by the manager’s inattention to risk rather than a
strong belief that small-cap stocks (as a class) will outper-
form large-cap stocks. By increasing noise in the denom-
inator (tracking error) without increasing the numerator
(active return), this practice reduces the information ratios
of traditional managers.
We believe the empirical information ratio advan-
tage for structured managers reflects two methodological
advantages: their relative freedom from the no-short con-
straint (due to smaller intended active deviations), and their
greater focus on risk management. If these methodolog-
ical advantages persist into the future, we would expect
the information ratio advantage to persist as well.
Given the historical information ratio advantage of
structured managers, investors might conclude from our
discussion that they should allocate little, if any, of their
active risk budgets to traditional active strategies. This is
not necessarily the case. There are at least two good rea-
sons to include traditional managers in the mix.
First, the information ratio advantage for structured
managers may not persist. Historical information ratios are
poor predictors of future performance, especially for com-
paratively small samples such as ours. Our sample uses quar-
terly data and has a relatively small number of structured
managers. Consequently, we should regard our statistical
results as suggestive rather than definitive.5 Prudent diver-
sification, then, should include process diversification, and
argues for using managers at both ends of the risk spectrum.
Second, at least some traditional managers have
added value historically, and their performance is relatively
uncorrelated with structured manager performance, sug-
gesting that investors can improve their expected infor-
mation ratios by allocating at least some of their active risk
budgets to traditional strategies. Thus, the real issue is the
size of the allocation to each active strategy, both relative
to one another and to the passive allocation.
THE JOURNAL OF PORTFOLIO MANAGEMENT 53
 FINDING THE RIGHT MANAGER MIX
How should investors allocate assets between active
and passive strategies? Should they adopt a barbell approach
or take risk across the entire active risk spectrum? What-
ever approach they ultimately adopt, investors should
carefully evaluate the trade-offs that accompany each key
decision. We believe the best way to assess these trade-offs
is through an analysis of the active risk budget (see Winkel-
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
mann and Howard [2001]).
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
There are three important concepts to clarify about
active risk budgeting: 1) the active risk budget; 2) the opti-
mal active risk budget; and 3) the active risk budgeting
process. An active risk budget is simply an attribution of
active risk to its constituent parts. Suppose an investor has
six domestic equity managers with different levels of
active risk. Armed with estimates of the correlations
among managers, it is quite straightforward to calculate
the tracking error of the portfolio of managers relative to
the combined benchmark, and then attribute the total
equity tracking error to each of the six managers. This
decomposition is the active risk budget.
Because the active risk budget identifies the sources
of active risk, it also provides important information
about the structure of an investor’s active equity portfo-
lio. In fact, there is a direct relation between the active risk
budget and an investor’s views about active returns.
In the absence of constraints, the total portfolio
information ratio is maximized when active risk is allo-
cated so that the marginal contribution to active perfor-
mance equals the marginal contribution to active risk for
all active investments. Constraints can alter this ideal rela-
tion, but any allocation of active risk that maximizes the
information ratio (for a given level of active risk) is called
an optimal active risk budget. The process of finding this opti-
mal active risk budget is the risk budgeting process.6
A simple example may help illustrate these points.
• Suppose an investor has two sources of active
performance: a portfolio of two structured man-
agers, and a portfolio of four traditional managers.
• To simplify the discussion, we assume active
returns are uncorrelated across all managers, an
assumption we will relax later on. (As Exhibit 1
shows, traditional and structured managers are
unlikely to have completely uncorrelated active
returns.)
• Reflecting the results of our historical analysis, we
also assume each structured manager has a track-
54 A SPECTRUM APPROACH TO ACTIVE RISK BUDGETING
ing error of 215 bp, while each traditional man-
ager has a tracking error of 800 bp.
• We assume each manager is equally weighted
within its type; i.e., each structured manager
invests 50% of the structured portfolio, and each
traditional manager invests 25% of the traditional
portfolio.
In this simple example, risk budgeting means decid-
ing how much of the active risk budget to allocate to each
group of managers.
Calculate Active Risk Level
To make the allocation decision, we must first cal-
culate the active risk level for each portfolio. Under our
assumptions, the tracking error for the portfolio of struc-
tured managers is around 152 bp, while the tracking error
for the portfolio of traditional managers is 400 bp. (These
calculations assume each portfolio of managers has a beta
of 1.0 relative to the benchmark index.)7
Estimate Active Returns
Recall that when there are no constraints, we should
allocate active risk so that the marginal contribution to
active risk equals the marginal contribution to active
return for all investments (or managers). Thus, the next
step is to estimate active returns for groups of managers.
For simplicity, let’s assume structured managers have
expected information ratios of 0.45, while traditional
managers have expected information ratios of 0.30. These
assumptions roughly correspond to the first-quartile fig-
ures in Exhibit 1, and imply the investor is skilled at
manager selection. By these assumptions, the expected
information ratio for the group of two structured man-
agers is 0.64, and the expected information ratio for the
group of four traditional active managers is 0.60. The
information ratios for the portfolios of managers are
higher than for any individual manager because we’ve
assumed the active returns are uncorrelated.8
Exhibit 3 summarizes our assumptions.
Blend Strategies
How should we build a portfolio that combines the
structured and traditional equity products? A simple way
to approach this problem is to vary the proportion invested
with the two equity programs and assess the impact on
FALL 2003
 EXHIBIT 3 EXHIBIT 4
Risk and Return Assumptions for Portfolios of Allocations to Portfolios of Top-Quartile
Top-Quartile Structured and Traditional Managers Structured and Traditional Managers
Number of Information Active Return Active Risk
Managers Ratio (bp) (bp) Structured Traditional Active Tracking
Allocation Allocation Return Error Information
Structured Equity 2 0.64 97 152 (%) (%) (bp) (bp) Ratio
Traditional Equity 4 0.60 240 400
100 0 97 152 0.64
90 10 111 143 0.78
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

the total information ratio and tracking error, as shown 80 20 125 146 0.86
in Exhibit 4. 70 30 140 160 0.87
An interesting pattern emerges in Exhibit 4. The 60 40 154 184 0.84
information ratio hits its maximum when the investor
50 50 168 214 0.79
blends structured and traditional managers. Under our
40 60 183 248 0.74
assumptions, the optimal portfolio allocates 70% to struc-
tured managers and 30% to traditional strategies. Of 30 70 197 284 0.69

course, the optimal proportions will vary depending on 20 80 211 321 0.66
the underlying information ratio assumptions.9 10 90 226 360 0.63
The central point remains the same. As long as the 0 100 240 400 0.60
expected information ratios for each strategy are positive
Assuming zero correlation between structured and traditional managers. The
and not perfectly correlated, investors achieve a higher structured portfolio comprises two uncorrelated managers, and the traditional
information ratio by combining strategies than they do by portfolio comprises four uncorrelated managers.
relying on either strategy exclusively.

Introduce Passive Management
to the Portfolio
So far, we have focused on the split between struc-
tured and active equity products, without discussing pas-
sive management. The reason is that, in active risk
budgeting, passive management is both a risk-free and
return-free strategy, while we have been focused on the
allocation of active risk between the two active return-
generating (i.e., risk-taking) strategies. How does passive
management fit into the mix?
The risk-free nature of passive management means
that investors can use it to dampen the total active risk of
their equity portfolios. The first step is to decide on an
appropriate level of total active risk (expressed in track-
ing error terms), and then to blend the optimal portfolio
of active strategies with passive management to hit this tar-
get (see Winkelmann and Howard [2001] for more details).
For example, suppose an investor decides that the
tracking error target for a U.S. equity program should be
200 bp. Suppose further the investor estimates that the
portfolio of traditional managers has a tracking error of
400 bp (as shown earlier) and an information ratio of 0.60.
If the investor allocates 50% of the total portfolio to a pas-
sive manager and 50% to the portfolio of traditional man-
FALL 2003
agers, the combined tracking error would hit its target of
200 bp. Under our assumptions, the expected informa-
tion ratio for the total domestic equity portfolio would
be 0.60. This, in essence, is the barbell strategy.
Evaluate Spectrum
Versus Barbell Approaches
With a spectrum strategy, however, investors can do
better. In Exhibit 4, a 70/30 mix of structured and tra-
ditional managers achieves the highest information ratio
(0.87). The tracking error of this mix, however, is 160 bp,
lower than the target of 200 bp.
Assuming the investor cannot lever the optimal
information ratio portfolio, the next best solution is to pick
the mix in Exhibit 4 that has a tracking error closest to
the target. This portfolio has roughly 55% invested in
structured strategies and the remaining 45% invested with
traditional managers. The new information ratio of 0.81
is almost 7% lower than the optimal information ratio. This
shortfall amounts to about 12 bp (200 bp ¥ [0.87 – 0.81])
in expected active return, which equals the efficiency
cost of the no-leverage constraint.
Relative to the barbell strategy, however, this new
mix represents a 35% improvement in efficiency (i.e.,
THE JOURNAL OF PORTFOLIO MANAGEMENT 55
 EXHIBIT 5
Results for Spectrum and Barbell Approaches at Selected Target Risk Levels
Spectrum Barbell

US Equity Passive Structured Traditional Passive Traditional

Target Risk Allocation Allocation Allocation Information Allocation Allocation Information
(bp) (%) (%) (%) Ratio (%) (%) Ratio

0 100 0 0 0.00 100 0 0.00

50 68 22 10 0.87 88 12 0.60
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

100 38 43 19 0.87 75 25 0.60

150 6 66 28 0.87 63 37 0.60
200 0 55 45 0.81 50 50 0.60
250 0 40 60 0.74 38 62 0.60
300 0 24 76 0.68 25 75 0.60
350 0 13 87 0.64 12 88 0.60
400 0 0 100 0.60 0 100 0.60

The spectrum approach combines passive, structured, and traditional strategies, and the barbell approach combines passive and traditional strategies. The structured
portfolio comprises two uncorrelated top-quartile managers, and the traditional portfolio comprises four uncorrelated top-quartile managers.

0.81 versus 0.60), and an improvement in expected active
return of 42 bp. The source of this efficiency gain is
moving from passive to structured management. In fact,
in this example, for any tracking error target above 160
bp, investors should have no passive exposure, and should
instead allocate all their equity assets to the structured and
traditional programs.
Next let’s look at an active risk target that is below
160 bp. Suppose the targeted tracking error is 100 bp for
the total U.S. equity portfolio. We know from Exhibit 4
that a mix of 70% invested in structured equity and 30%
invested with traditional managers has the highest infor-
mation ratio. This portfolio has a tracking error of 160 bp.
If we construct a portfolio that has 38% invested pas-
sively, and 62% invested in the optimal blend portfolio,
the total portfolio will hit the tracking error target of 100
bp. Thus, the passive position effectively diminishes the
active risk in the optimal blend portfolio without reduc-
ing the total portfolio’s information ratio. The total port-
folio now has an information ratio of 0.87, and an
expected active return of 87 bp, with 38% invested pas-
sively, 43% invested with structured managers, and 19%
invested in traditional strategies. Thus, this portfolio
clearly takes risk across the spectrum.
How does this optimal portfolio compare to the bar-
bell strategy? To achieve a targeted tracking error of 100
bp in the barbell strategy, the investor would need to
allocate 25% to the traditional portfolio and 75% to the
passive portfolio. This portfolio would have an informa-
tion ratio of 0.60. We can easily see that the structured
equity allocation comes almost entirely from the passive
position. By putting more of the passive assets to work in
a structured equity program, the information ratio for the
total U.S. equity portfolio increases from 0.60 to 0.87, or
almost 45%.
Exhibit 5 summarizes these two examples, and pro-
vides the strategy split and information ratios for other
tracking error targets. It contrasts these figures with the
barbell strategy. The information ratio increases as risk is
taken along the active risk spectrum. What is more strik-
ing, though, is that for the most part, funding for the struc-
tured equity position comes out of the passive allocation.
Change the Correlation Assumption
So far, our analysis has assumed active returns are
uncorrelated across management type and across managers
within each management style. This assumption has been
roughly consistent with the observed median correla-
tion, as shown in Exhibit 1. What happens to the infor-
mation ratio if we assume the correlations are higher?
Suppose the pairwise correlations are close to the top-
quartile level in Exhibit 1, an average active return corre-
lation among structured managers of 0.25, and an average
correlation among traditional managers of 0.35. We will
continue to assume each prospective manager in each strat-

56 A SPECTRUM APPROACH TO ACTIVE RISK BUDGETING FALL 2003

 EXHIBIT 6
Results for Selected Correlation Levels at 2% Target Tracking Error
Structured Traditional Number of Number of
Manager Manager Structured Traditional
Correlation Correlation Managers Managers
0.00 0.00 2 4
0.25 0.35 2 4
0.25 0.35 2 8
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
egy can generate top-quartile risk-adjusted performance.
In the two-manager structured equity program, the
tracking error increases by about 12%, going from 152 bp
to 170 bp. This increase in tracking error reduces the infor-
mation ratio for the structured portfolio from 0.64 to 0.57.
For the traditional equity program, the higher correlations
increase the overall tracking error by 44%, from 400 bp
(with four managers) to around 575 bp. As with the
structured program, the information ratio declines, going
from 0.60 to 0.42. Thus, the higher increased correlation
among traditional managers produces more significant
deterioration in their total tracking error and information
ratios.
Suppose an investor decides to improve the efficiency
of the traditional program by doubling the number of
managers. The tracking error for the traditional program
would fall from 575 bp to 525 bp. Correspondingly, the
information ratio would increase from 0.42 to 0.46. Thus,
the higher correlation of active returns among traditional
managers may produce an incentive to hold more tradi-
tional managers in a portfolio.10
This higher correlation does not mean, however, that
investors should allocate more assets to traditional man-
agers. In fact, the opposite is true. When the correlations
among traditional managers increase, investors should
allocate more assets (i.e., more of the active risk budget)
to the structured equity program. We can see the impact
on the active risk budget in Exhibit 6.
Suppose an investor has a tracking error target for
the overall active program of 200 bp. When the correla-
tion of active returns is zero, we determine that a 55/45
blend of structured and traditional managers achieves the
target tracking error. This blend has an expected infor-
mation ratio of 0.81.
All else equal, higher correlations mean higher
tracking errors and lower information ratios for both
active programs. Because the correlation increases more
for the traditional program, however, its tracking error also
FALL 2003
Structured Traditional
Allocation Allocation Information
(%) (%) Ratio
55 45 0.81
70 30 0.67
70 30 0.71
increases more (and its information ratio falls more).
Consequently, investors should allocate more assets
to the structured program in order to neutralize the
impact of higher active risk in the traditional program. In
fact, it now takes a 70/30 mix to hit the risk target of 200
bp. The information ratio for the combined program is
now 0.67, which amounts to a decline in expected return
of 28 bp relative to the zero-correlation case. This high-
lights the importance of finding managers with indepen-
dent and uncorrelated sources of active return.
Assume Median Skill Levels
The expected information ratio for the U.S. equity
program will also vary with the investor’s views about
manager selection skill. By using first-quartile informa-
tion ratios for both structured and traditional managers,
our examples implicitly assume skill in manager selection.
Suppose we are less confident in our ability to pick man-
agers, and instead decide to use median information ratios
in our analysis. What happens to the mix of passive, struc-
tured, and traditional managers?
Clearly, the expected information ratio for the total
U.S. equity portfolio will decline at all tracking error lev-
els. Exhibit 7 illustrates this point by showing the active
return, tracking error, and information ratio for alterna-
tive allocations between structured and traditional man-
agers. As in Exhibit 4, we assume portfolios of two
structured managers and four traditional managers. Con-
sistent with the median values in Exhibit 1, we also assume
each structured manager has an expected information
ratio of 0.30, and each traditional manager has an expected
information ratio of 0.10. If we further assume there is no
correlation between managers’ active returns, the portfo-
lio of two structured managers has an expected informa-
tion ratio of 0.42, while the portfolio of four traditional
managers has an expected information ratio of 0.20.
Notice in Exhibit 7 that the maximum information
THE JOURNAL OF PORTFOLIO MANAGEMENT 57
 EXHIBIT 7 structured equities and 45% to traditional strategies. Now,
Results for Alternative Allocations though, the expected information ratio is much lower at
0.36, versus 0.81 when we assumed greater skill at man-
Structured Traditional Active Tracking ager selection.
Allocation Allocation Return Error Information
(%) (%) (bp) (bp) Ratio
For a more interesting case, suppose the tracking
error target is 100 bp. Since this target is lower than the
100 0 65 152 0.42
tracking error of the optimal blend portfolio, we know
90 10 66 143 0.46 we will need to dilute the active risk with passive man-
80 20 68 146 0.46 agers. Exhibit 8 contrasts the mix among passive, struc-
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

70 30 69 160 0.43 tured, and traditional managers at the 100 bp tracking error
60 40 71 184 0.38 target under our two assumptions for manager informa-
tion ratios.
50 50 72 214 0.34
The results in Exhibit 8 are quite interesting. When
40 60 74 248 0.30
investors use the median information ratios (i.e., no par-
30 70 75 284 0.27 ticular skill in manager selection), the allocation to struc-
20 80 77 321 0.24 tured equity increases. Moreover, while the allocation to
10 90 78 360 0.22 structured equity is funded out of both the passive and tra-
0 100 80 400 0.20 ditional strategies, the impact is more pronounced on
the passive program.

ratio is achieved when the portfolio has between 80% and
90% allocated to structured equities and 10% to 20%
allocated to traditional strategies. This portfolio has an
expected information ratio of around 0.46 and a track-
ing error between 143 bp and 146 bp. Compared to
Exhibit 4, the tracking error for the optimal mix is lower,
while the allocation to structured equity strategies is
higher. This result should not be surprising, given the rel-
ative declines in information ratios (from top-quartile to
median) for the two strategies.
Now, let’s suppose the target tracking error for the
total U.S. equity program is 200 bp. Since this target is
higher than the tracking error for the optimal portfolio,
we know risk considerations will determine the optimal
split between structured and traditional strategies. In par-
ticular, the allocation to structured strategies will be
exactly the same as when we used first-quartile manager
information ratios.
As Exhibit 7 suggests, we will still allocate 55% to
Assume Equal Skill Levels of
Structured and Traditional Managers
The assumptions underlying the analysis of Exhibits
4 and 5 are that there are differences between structured
and traditional managers, and that investors are skilled in
manager selection. In Exhibits 7 and 8, we assume that
investors are neutral in their abilities to pick managers, but
that the differences between structured and traditional
managers are expected to continue.
The implication for portfolio strategy in both cases
is that investors should move away from a barbell strategy
and take active risk across the active risk spectrum. They
should do so by reducing their passive positions and
adding structured active equity programs.
There is a final possibility that deserves consideration.
Suppose investors believe there are no long-term perfor-
mance differences between structured and traditional man-
agers, and that they are not skilled in manager selection.

EXHIBIT 8
Results for Optimal Allocations at 100 bp Tracking Error

Passive Structured Traditional Active Tracking

Manager Allocation Allocation Allocation Return Error Information
Skill (%) (%) (%) (bp) (bp) Ratio

Top Quartile 38 44 18 87 100 0.87

Median 32 54 14 46 100 0.46

58 A SPECTRUM APPROACH TO ACTIVE RISK BUDGETING FALL 2003

 An easy way to reflect the assumption of no difference
between structured and traditional managers is to assume
the median information ratio for all managers is 0.20,
approximately halfway between the median information
ratios shown in Exhibit 1. Under this assumption, port-
folios of two structured managers and four traditional
managers will have information ratios of 0.28 and 0.40,
respectively. The optimal information ratio portfolio has
60% allocated to the structured program and 40% allocated
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
to the traditional program, with an overall tracking error
of 184 bp and an overall information ratio of 0.49.
The dollar allocation to the structured program is
higher, despite the lower information ratio, because risks,
not dollars, are allocated in proportion to the information
ratio. That is, we actually allocate more risk to the tradi-
tional program despite the lower dollar allocation.
Suppose the total tracking error target is 200 bp. As
in our earlier examples, the allocations to each strategy are
driven by risk rather than information ratio considerations.
Consequently, 55% of the portfolio is allocated to the port-
folio of structured strategies, and 45% is allocated to the
portfolio of traditional strategies.
Now, let’s see what happens at a lower tracking
error target. Suppose the tracking error target is 100 bp.
In this case, the proper strategy is to make allocations to
the optimal information ratio portfolio and the passive
strategy. The optimal blend is now 46% allocated to pas-
sive, 32% allocated to the structured portfolio, and 22%
allocated to traditional strategies. This allocation pro-
duces an expected information ratio of 0.49.
So, even when investors believe there is no infor-
mation ratio advantage to structured strategies, and they
have no skill at manager selection, it is still optimal to fol-
low the spectrum strategy, and allocate substantial dollar
amounts to structured equities.
CONCLUSION
We have reviewed a basic issue most institutional
investors face: how to allocate assets between active and
passive strategies. Many investors adopt a barbell approach
that achieves their active risk targets by blending traditional,
high-tracking error, active managers with passive index
funds. By including passive management, however,
investors are forgoing active returns on what may be a sig-
nificant portion of their portfolios.
We believe most investors would benefit from
putting this capital to work in structured equity pro-
grams. Most investors can achieve potentially significant
FALL 2003
improvements in active returns and information ratios by
reducing their passive allocations and replacing them with
allocations to structured equity. We show that by allocat-
ing risk across the active risk spectrum, investors can sig-
nificantly enhance the expected active performance of
their U.S. equity portfolios.
The actual optimal risk allocations will depend on
investor assumptions about the ability of active managers
to outperform their benchmarks. Using historical sepa-
rate account data, we have shown that the median and top-
quartile information ratios for structured managers have
exceeded those of traditional managers. This result is not
surprising. Given their lower tracking error objectives,
their focus on reducing unintended risks, and their rela-
tive freedom from the no-short constraint, we would
expect realized information ratios to be higher for struc-
tured managers.
Thus, investors should not be alarmed by the rela-
tive differences in historical information ratios. If these dif-
ferences persist, the practical implication is that investors
will continue to need traditional managers on their active
manager rosters—although possibly with somewhat
smaller allocations. Our analysis also shows that manager
selection is extremely important among traditional man-
agers. Investors developing a portfolio of traditional
managers should balance the benefits of diversification
against the higher fees and monitoring costs that come
with manager proliferation.
Our main conclusion is that investors should allo-
cate risks across the entire active risk spectrum. Moreover,
when moving from a barbell approach to a spectrum
strategy, the allocation to structured managers is more
likely to come from the passive side than from the tradi-
tional active side.
Finally, this conclusion is reasonably insensitive to dif-
ferent assumptions about manager information ratios and
correlations. Given reasonable expectations based on his-
torical experience, most investors can benefit from adding
a healthy percentage of structured management to their
active equity programs.
ENDNOTES
This article represents the work of its authors, and should
not be taken to reflect any opinion of their employer.
1
Structured refers to low-tracking error managers, who are
often called enhanced-index or benchmark-sensitive managers. Tra-
ditional refers to concentrated active managers who usually
have higher tracking errors and are less benchmark-sensitive.
THE JOURNAL OF PORTFOLIO MANAGEMENT 59
 2 8
The returns in the PSN database are gross of fees and sub-
ject to both self-selection and survivor bias. Only managers who
choose to submit are included (presumably those with better
returns), and managers who fail or merge are dropped. Thus,
our median results may actually be a bit above the median.
Because these biases affect both manager styles, however, we
believe comparisons of structured and traditional managers are
valid.
3
These results showing higher information ratios for
structured managers vis-à-vis traditional managers are consis-
The Journal of Portfolio Management 2003.30.1:49-60. Downloaded from www.iijournals.com by SIMON FRASER UNIVERSITY on 12/24/15.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
tent with a study of mutual funds by Brown and Harlow
[2002], which shows a clear connection between consistency
of investment style and active risk levels and persistence of per-
formance. Generally, a high level of consistency corresponds
to lower active risk levels and more persistent benchmark
outperformance.
4
Untabulated results show that investors can improve
the expected information ratio of the portfolio of traditional
managers by classifying managers by style (growth versus value)
and selecting from each group in equal proportions.
5
For example, the t-statistic on the difference between
median information ratios for portfolios of four structured and
traditional managers is 1.72, which is significant at the 11% level.
This result means that we cannot reject the hypothesis of no
difference between manager types at the 95% confidence level,
but we can at the 89% level.
6
Of course, this works only if we assume active risk is
uncorrelated with the underlying strategic asset allocation. If the
active returns are negatively correlated with the underlying
assets, then the total portfolio information ratio could be
improved by using a suboptimal active portfolio. In practice,
the correlation between active risk and the strategic asset allo-
cation is quite low.
7
The tracking error of 152 bp for the portfolio of two
structured managers is calculated as the square root of the sum:
(1/2 ¥ 215)2 + 2 ¥ 1/2 ¥ 1/2 ¥ 0 ¥ 215 + (1/2 ¥ 215)2. The
zero in the middle term represents the correlation assumption.
A similar approach applies to the portfolio of the four traditional
managers.
60 A SPECTRUM APPROACH TO ACTIVE RISK BUDGETING
These information ratios differ from the top-quartile
information ratios in Exhibit 2 because here we are building a
portfolio of top-quartile managers, while in Exhibit 2 we were
analyzing a top-quartile portfolio of managers. Thus, here we
are assuming considerably more skill at manager selection.
The median correlation between active returns for the
structured and traditional portfolios is 0.07.
9
Exhibit 4 assumes the allocation of active risk is consid-
ered independently from the strategic asset allocation. To put
it differently, Exhibit 4 assumes the investor first develops a tar-
get for total active risk in the U.S. equity portfolio, and then
optimizes the manager structure.
10
Of course, the diversification benefit of adding more man-
agers must be balanced against the real cost of potentially higher
fees and monitoring costs. Adding more managers with lower
allocations per manager makes it less likely that investors will be
able to achieve fee breaks. In addition, selection and monitor-
ing costs are likely to rise as the investor adds more managers.
REFERENCES
Brown, Keith C., and W.V. Harlow. “Staying the Course: The
Impact of Investment Style Consistency on Mutual Fund Per-
formance.” Working paper, McCombs School of Business,
University of Texas at Austin, March 2002.
Winkelmann, Kurt, and Ron Howard. “Developing an Opti-
mal Active Risk Budget.” Goldman Sachs Investment Man-
agement Research, July 2001.
To order reprints of this article, please contact Ajani Malik at
amalik@iijournals.com or 212-224-3205.
FALL 2003