Optimal Holdings of Active, Passive and Smart Beta Strategies

Institutional equity portfolios are increasingly dominated by a large passive core and a smaller constellation of high tracking error satellite portfolios – the core and explore approach. We examine the role of lower tracking error strategies such as enhanced index and smart beta in this core and explore world. In the conventional approach where risk is volatility and for a fixed target excess return implied by the core and explore model, the lower tracking error strategies can only lower tracking error. We study this problem from the perspective that investment risk is not having what you need when you need it. We find that for moderate excess return targets and long horizons, enhanced index and smart beta strategies play an important role in reducing investment risk.