All this week we are running a Guide to Active and Passive Investing to help you, the investor, make smart choices for your portfolio.
Morningstar's analyst team has long held the view that investors can assemble successful portfolios composed exclusively of index funds, entirely of actively managed funds, or a combination of the two. Just how much they allocate their portfolios in one direction or another depends on their personal characteristics: the type of account they're investing in, how many holdings they'd like to maintain, and how much ongoing management of their portfolios, among other factors.
As you think through your own portfolio's allocations to active and passive management, and I would put individual-stock investments under the "active management" umbrella, ask yourself the following questions:
Question 1: How Big a Concern is Tax Efficiency?
Concern/investing in outside of an ISA or SIPP: Favour equity index funds
Not a concern/investing primarily in an ISA or SIPP: Favour either active or index funds
If you're investing in a taxable account, broad-market index funds or exchange-traded funds will tend to be a better fit for your portfolio's equity exposure than actively managed products. That's because broad-market index funds and ETFs have low turnover.
Actively managed equity funds, by contrast, usually have higher turnover, and more-frequent selling can translate into more-frequent capital gains distributions. Of course, tax is not an issue if you're investing in a tax-efficient account such as an ISA, SIPP or your company retirement plan. As a fund can make capital gains distributions every day and you still won't owe taxes on them.
Also, bear in mind that even though ETFs and index funds are more tax-efficient in the equity space, the tracker/ETF format has no low-tax advantages when it comes to bond funds. Instead, bond funds must pay out the income to shareholders of bond ETFs, index funds, and actively managed funds on an ongoing basis, and shareholders in taxable accounts will owe income tax on those coupons.
Question 2: Do you aim to beat the market or are you content to match its return, less investment costs?
Aim to beat the market: Favour active funds
Content to match it, less costs: Favour index funds
It's an open question whether you'll be able to do so, but if you're determined to beat the market – either on the basis of raw returns or risk-adjusted returns – you have no choice but to invest in actively managed funds or actively manage your own portfolio of individual stocks.
Just be aware that beating the market sounds easier than it is. Not only do actively managed equity funds, in aggregate, have an underwhelming track record of beating appropriate benchmarks, but investors don't always fully benefit when they do because they've jumped in and out at inopportune times.
From that standpoint, accepting the market's return, less expenses – as index-fund investors do – isn't as underwhelming of an investment approach as it might first appear.
Question 3: Is Risk Control a Key Consideration?
Yes: Favour active funds that emphasise absolute returns
No: Favour index funds
The longer I've focused on investing, the more I've come to conclude that one of the key virtues of active strategies is the ability to control risk. It's something that many of the best, most thoughtful managers are able to excel at. Because active managers can build cash or avoid overvalued market sectors, they have the potential to keep volatility down relative to index products that have no such latitude.
Not only do relatively strong returns in down markets mean that defensive active managers have less ground to make up in rallies, but Morningstar data have tended to show that lower-volatility strategies do a better job of keeping investors in their seats.
Of course, it's worth noting that many active managers don't take advantage of such defensive techniques, so don't assume that active management equates to good volatility smoothing.
Question 4: How Good is Your Track Record?
Have had much self-selected success: Favour active strategies
Minimal or poor past track record: Favour index funds
Be honest: If you've relied on active management in the past – either actively managed funds or your own individual-security selections – how successful have you been at picking managers and stocks? If you haven't added value by selecting and maintaining active managers or picking individual securities, you're better off investing all or part of your portfolio to index funds.
And even if you have had great success with an actively managed portfolio, you may still want to consider adding a slice of index exposure. Not only does broad-market exposure tend to improve the risk/reward characteristics of the total portfolio, but adding additional diversification may make you more likely to stick with your actively managed holdings when they encounter a downturn.
Question 5: How Patient are You With Big Performance Swings Versus a Market Benchmark?
Not very patient: Favour index funds
Very patient: Favour active funds
Several of the previous points have hinted at the role of behaviour in all of this. To perform better than a broad-market index and/or a peer group, an active fund or strategy has to be appreciably different from its benchmark and/or its peers.
High-conviction, idiosyncratic strategies have the potential to deliver market-beating performance over long periods of time, but they can also lead to sustained bouts of underperformance relative to a peer group or index. Thus, even if a fund manages to best its peers or its benchmark, investors may not capture that success if they abandon it during performance troughs.
Passive funds don't always perform well, to be sure, but the index fund investor can at least take comfort in knowing that she's not performing much worse than the market at any given point in time.
Here's another area where reflecting on your own past behaviour can help determine whether you're a good fit for active management or whether you're better off sticking with index funds, which might be easier to own.
Question 6: How Much Do You Want to Manage Your Portfolio?
Not much oversight: Favour index funds
Some oversight: Favour either active or index funds
From an ease-of-use standpoint, broad-market index funds have it all over actively managed products. It takes much less effort to analyse index funds than active – costs and index construction are the two keys, whereas the prospective active-fund investor must consider softer factors such as management, strategy, and stewardship.
Index funds will also tend to be easier to oversee on an ongoing basis, and rebalancing an all-index portfolio is a cinch. Those limited oversight responsibilities are a key reason I often urge retired investors – especially older retirees who don't have the time or inclination to be very hands-on with their portfolios – to consider a streamlined, index-centric portfolio.
Question 7: Is A Streamlined Portfolio a Goal?
Yes: Favour index funds
No: Favour active funds
In a related vein, index funds can make good sense for portfolio minimalists. By buying total-market index funds – one for developed market stocks, one for emerging market stocks, and one for bonds – investors can gain exposure to a huge swath of securities in three highly economical packages. Indexers can skinny down their portfolios even more by using index-based balanced funds or world-stock funds.
Meanwhile, it might take a few more holdings to build an active portfolio that's truly diversified, though it's not impossible. Morningstar's various allocation categories feature many fine active funds that could easily be used as core or standalone holdings.
