Balancing risk and reward in active investing

Combining active products isn’t as easy as picking a fund from the value, core, and growth style boxes and allocating to each one equally. This is particularly true today, given the highly concentrated U.S. stock market, which has been a headwind for most active managers. 

At Vanguard, we draw on nearly 40 years of experience blending complementary active strategies within our multimanager funds, such as Vanguard Windsor™ Fund or Vanguard International Growth Fund. These funds combine portfolios from leading active managers into a single mutual fund. The portfolio construction exercise behind these funds can serve as a guide for investors who want to build an active portfolio. As the number of active ETFs continues to grow, investors face exciting opportunities and new challenges. We’re sharing this guidance to help investors cut through the complexity, make informed choices, and construct an active equity portfolio that supports their long-term goals.

Define your intended risk profile. Combining active managers requires balancing your confidence in each manager with their role in the portfolio and their contribution to the overall intended risk-reward profile. Do you want to tilt the portfolio toward certain factors (for example, value) that you believe will outperform over time? Do you want to take more risk than the market or less?  

Know the strategies. It’s essential to understand the investment approaches, style factor biases, and performance patterns of the specific active strategies you are considering. 

Test a variety of allocations. Once you establish those foundations, test different allocations to analyze the exposures within the total portfolio and compare that to the portfolio benchmark. This step helps ensure that unintended risk factors don’t swamp the stock-picking skills that presumably drew you to the managers in the first place.  

Here are three ETFs that together illustrate one way an investor could build an active equity portfolio:

• Vanguard Wellington™ U.S. Growth Active ETF (VUSG) provides concentrated high-growth exposure by targeting innovative companies that have the potential to deliver long-term growth regardless of the economic cycle.

• Vanguard Wellington U.S. Value Active ETF (VUSV) employs an opportunistic, contrarian value strategy.

• Vanguard Wellington Dividend Growth Active ETF (VDIG) offers defensive exposure by targeting high-quality companies that can grow their dividends over time.

For a portfolio designed to maintain a balanced profile relative to a U.S. core benchmark, our analysis suggests an allocation of 50% VUSG, 30% VUSV, and 20% VDIG. This mix is most effective at maximizing stock-specific risk and minimizing style risk, thus allowing the managers’ stock-picking skills to shine through.

The overweight to VUSG isn’t based on a belief that growth stocks will outperform. Given the concentration of mega-cap tech stocks in the U.S. market (the Magnificent Seven), an equal-weight approach would create a structural underweight allocation to this cohort because of the defensive and value-oriented nature of VUSV and VDIG. The 50/30/20 portfolio helps avoid that underweight while maintaining notable relative differences within the cohort driven by the stock-level positions in VUSG.

Compared with the individual ETFs, the model portfolio reduces tracking error and neutralizes style risk more than stock-specific risk, thus keeping active risk focused on security selection.

Of course, your goals might be different. For example, if you want a more defensive portfolio, it may make sense to increase your exposure to VDIG over VUSG and VUSV. It’s all a question of tradeoffs. 

We believe that, for investors who have already gravitated toward incorporating active ETFs as key components in their portfolios, it’s worth finding a baseline allocation that maximizes stock-selection alpha by minimizing other relative risk factors. From that baseline, you can adjust depending on your convictions and goals.