Equity Valuation and Portfolio Management

THE RISK-RETURN CONTINUUM

The various approaches to investment management, as well as the selection universes that are the targets of such approaches, can be characterized generally by distinct risk-return profiles. For example, in Exhibit 6.1, risk levels tend to increase as one moves from the core outward toward the dynamic view of the market; expected returns should also increase. Similarly, in Exhibit 6.4, risk can be perceived as increasing as one moves from passive investment management out toward traditional active management; expected returns should also increase.

Where should the investor be along this continuum? The answer depends in part on the investor's aversion to risk. The more risk-averse the investor, the closer to core/passive the portfolio should be, and the lower its risk and expected return. Investors who are totally averse to incurring residual risk (that is, departing from benchmark holdings and weights) should stick with passive approaches. They will thus be assured of receiving an equity market return at a market risk level. They will never beat the market.

Less risk-averse investors can make more use of style subsets (static or dynamic) and active (engineered or traditional) approaches. With the use of such subsets and such approaches, however, portfolio weights will shift away from overall equity market weights. The difference provides the opportunity for excess return, but it also creates residual risk. In this regard, engineered portfolios, which control ...