Debate topics can be political, informative, funny, social, and economic. Many are controversial, heightening the level of seriousness, especially when discussing politics or one’s core value systems. But sometimes a debate is maybe not a debate at all.
In portfolio management, active versus passive management is often a serious debate, though I would argue that it is a false dichotomy. To set the stage, let’s define each component. Passive management is structured so that an investor can expect a return that closely replicates the investment weighting and returns of the benchmark index. Many passive strategies are considered index funds with the characteristics of low cost and minimal divergence from the benchmark. By contrast, active management is a strategy where the manager makes specific investments with the goal of outperforming an investment benchmark. Many financial experts refer to passive management as “core” investments and active management as “satellite” investments.
And thus, the question debated in portfolio management is which one is better, active or passive? In recent years active management has struggled to outperform against the index-like versions of passive management in certain investment categories (see chart below). For instance, the bell-weather of investing is often the large company stock category of the United States. Over the course of the last ten years, on average, investors may have been better off in passive investments. But the bell-weather of fixed income, which can be represented by intermediate bond funds or corporate bond funds, active managers generally outperformed a representative passive index.
But in addition to performance measures, there may be other considerations for an active manager, not recognized in the index fund. For example, what if the active manager would achieve similar returns with considerably less risk? One of the most important fundamental traits of a solid active manager is reasonable cost which is primarily found in institutional mutual funds and low-cost active ETF’s. If a retail investor only has access to higher cost active strategies or investments, their experience in active management may be at a disadvantage. Additionally, an investor also needs to ensure that an active, when combined with a passive strategy, offers a unique risk/return experience not found with an all active or all passive strategy.
Simply put, active or passive can be the better choice in various categories depending upon the opportunities and lack of available information within those securities. And in certain categories, it may be best to marry the two. At Fragasso, we call this our core-satellite portfolio.
Passive index management should represent the core positions, offering low cost, tax efficient index returns. Active management is best served representing the satellite positions where strong managers within low-cost institutional mutual funds or active ETFs offer the potential for index-beating returns during abnormalities in the overall market or where alpha, which is the excess return of the fund or security used relative to the return of the benchmark index, can be captured.
Ending the debate is simple. Active and passive are not mutually exclusive and can in fact, not only coexist, but complement each other in an investment portfolio. At Fragasso, we feel a core-satellite approach that leverages the benefits of both active and passive management creates a stronger portfolio positioned to accomplish one’s financial and life goals and brings together the best of both worlds.