In order to meet its overall fund objective, a plan sponsor with multiple investment managers should depend, not only on its managers’ individual performances, but also on its own skill in efficiently allocating assets among managers.
Each manager’s area of expertise can be identified with a benchmark portfolio. The manager’s skill can then be defined as the difference between the performance of the manager’s actual portfolio and the performance of the benchmark. The sponsor’s overall fund objective can be defined as having higher utility than a broadly diversified target portfolio such as the S&P 500.
The sponsor can sharply reduce or eliminate the risk than its overall fund will stray significantly below the target portfolio by using a dynamic completeness fund—a portfolio whose holdings lower the tracking error between the managers’ aggregate benchmark portfolio and the sponsor’s target portfolio. For a plan sponsor that wishes to outperform its target portfolio while tracking that target closely, a dynamic completeness fund will always be as good as or better than an index fund.
