Indexing and active management may seem like opposite sides in a debate. For some investors, if one strategy is right, the other must be wrong. In reality, combining the two very different approaches to portfolio construction can add value.
Broad-market index funds combine diversification with low cost, a strategy that has historically outperformed most actively managed funds. On the other hand, because active manages veer from the market-cap weightings typical of most indexes, they provide the opportunity of out performance in their benchmarks, as well as the risk of lagging them.
Under the right circumstances, active and passive components can complement each other by moderating the swings between the extremes of relative performance. Such a combined strategy can help avoid the pangs of regret that investors might otherwise experience when one approach trumps the other.
The case for indexing
Approximating the returns of the target market. Index funds are straightforward tools in executing your allocation strategy and capturing the return of the target asset classes. Given successful tracking, index funds should only underperform their target benchmark by the amount of operating and trading costs - an inherent performance advantage over most active strategies, which typically entail higher expense. In the past, index funds have outperformed the majority of active funds over the long term.
Applicability to virtually any market segment or asset class. The same strengths that make indexing a good strategy for broad asset class exposure also apply to market segments within those asset classes. Because investments in small-cap and international markets generally may entail higher costs, the active manager has to overcome a higher hurdle to add value, making indexing an attractive alternative.
Transparency. Because they are designed to track an index and hold the same securities (or a representative sample), index funds are transparent and easy to understand.
Tax-efficiency. Depending on the index, passive strategies typically realize lower capital gains than comparative active funds, making them potentially more tax-efficient.
Diversification within a market segment. Index funds often have more securities than a typical active fund.
The best of both worlds
Because the methods used to construct active and passive strategies often result in portfolios that are not identical, their performance can vary. As a result, there are periods when indexing outperforms and periods when active management outperforms, suggesting that mixing the two strategies might avoid the extremes in relative performance.
As noted earlier, low costs can increase the probability of out performance, but there are other important factors to consider when selecting an active manger.
Some active managers are highly index oriented or "index-sensitive," typically targeting a modest amount of excess return and acceptable deviation from the benchmark. However, "index-agnostic" managers attempt to add as much alpha - excess return relative to a benchmark - as possible with little concern for volatility. Others are in between, following an "index-aware" approach. All are legitimate strategies.
A clearly defined investment philosophy and a consistent approach, regardless of market cycles, are important. Consider a manager long-term performance record relative to the appropriate benchmark.
Combining well-chosen active managers with indexing can provide a Goldilocks effect - not too hot, not too cold - that might be appropriate for investors.
The case of active management
The opportunity for out performance. As long as investors make behavioral and informational errors, there will be opportunities to outperform the market. Many investing decisions are emotionally driven. On any given day, investors may under react or overreact to news, trading securities at prices unequal to their real values.
Investors also vary considerably in their ability to assimilate and interpret data, and in their discipline and insight. These behaviors and the range of investors' sophistication create inefficiencies in the marketplace.
A disciplined, insightful manager who can identify enough of these opportunities to overcome the higher costs of active management can add value.
Other aspects to consider
The difficulty of identifying a winner in advance. As hard as it can be to find successful active manages, it may be even more difficult to pinpoint those who are consistently successful. For example, of the actively managed U.S. equity funds that landed in the best-performing quintile during the five years through 1997, only about one in five remained in the top quintile during the subsequent five-year period. Another one in five landed in the bottom quintile. Almost 13 percent were merged or went out of existence (Source: Derived from date provide by the Center for Research in Security Prices. All 1,044 nonindex U.S. equity funds with at least three years of history as of December 31, 1997, were considered.)
The drag of high costs. The real value of active management depends on manager talent and competitive costs, and both demand effective due diligence from the financial advisor or the investor. When selecting a manager, consider whether they can effectively implement a sound strategy and not lose too much of the potential return of costs, which include management fees, transaction costs and taxes.
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Smith Barney does not provide tax and/or legal advice. Please consult your tax and/or legal advisors for such advice.
• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.