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Advanced Thought Leadership for Your Money®

  • Writer's pictureAaron Kolkman

MVO PART V - Optimize Beyond the Index

Portfolios fund financial plans, therefore an optimal investment model is critical. Indexing is optimal by default: it offers investors the full risk and full return of the relevant marketplace. Headlines are made when a portfolio manager beats market (index) returns for a period of time (there is presently a dearth of headlines in the second-longest-running bull market in U.S. history, which began March 6, 2009). Unfortunately, few (if any) headlines are made with more consistency than the relevant marketplace. After all, it is not exciting to say “investors were rewarded with a similar result to the marketplace, but with less overall risk.” Nonetheless, active management can be the answer to optimizing beyond the index. Consider the following data, which illustrate a global, multi-asset-class investment model

3-Year 5-Year 10-Year

Bmark Passive Active Bmark Passive Active Bmark Passive Active

Standard Deviation 10.81 10.81 7.75 10.28 10.28 7.34 16.91 16.91 12.59

Mean 8.61 8.61 8.60 10.38 10.38 8.99 7.36 7.36 8.95

Sharpe Ratio 0.79 0.79 1.02 1.02 1.02 1.15 0.51 0.51 0.72

All data from Morningstar, Inc. (through 06/14/18)

Benchmark: DJ Aggressive TR USD


The passive investor receives the index risk/return, while the active investor does not. In our example, the active investor instead received a nearly identical return on a 3-year historical basis, a lower return on a 5-year basis, and a greater return on a 10-year basis. Total risk (measured by Standard Deviation) was lower across the board. The combination of risk and return – the Sharpe Ratio – was superior across the board, for the active investor. The greatest contributor to

this increase in Sharpe Ratio was substantially lower risk in each time period.


In summary, the passive investor whose holdings mirror the index, will be optimized in terms of what the market bears for risk and return – no better, no worse. The active investor can either 1) beat the index on returns, or 2) beat the index on risk-adjusted returns. If portfolio managers can offer a superior Sharpe Ratio, their services should be seriously considered. If not, an indexed approach may be preferable. Either way, the portfolio plays a supporting role to a comprehensive plan – a plan dependent upon consistency of investment results. The next edition of The Risk Manager examines the effect of advisory fees on this optimization analysis, to aid investor decision-making after fees, not because of fees.

The Risk Manager delivers intelligent, actionable content related to managing primary financial risks throughout the Life Cycle of Wealth. It can assist the reader in applying advanced financial concepts to a given situation with a well-informed and financially conservative viewpoint. The ultimate purpose of this work is to bring the reader less uncertainty and a greater ability to achieve life goals.

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