Advisors historically invested exclusively in either active strategies or passive strategies, rarely using them together. We are proponents of blending the two strategies, having the firm belief that combining active and passive strategies provides a superior risk-return profile than exclusively using one or the other.

We’re not the only ones who are seeing the virtues of blending active and passive investments. Many advisors are recognizing the benefits of integrating high value-added active strategies with low-cost, tax-efficient passive strategies. However, many advisors also make the active/passive decision subjectively, often being overly influenced by buzz surrounding the latest hot performing fund or investment vehicle.

We think it worthwhile to share the framework and thought process that we use, which we think removes most behavioral biases from the investment process. Using such a framework and following such a process provides a better investing solution to your end clients, we believe, while also making the advisor more efficient.

The Active/Passive Decision Framework

Deciding whether to invest in active or passive strategies is based largely upon a review of historical data for the asset classes under consideration. The bar is set pretty high for active management to beat passive, given the “headwind” of transaction costs and taxes. Because of the natural cost and tax advantages of passive funds, in essence active funds have to prove themselves to be superior in order to prevail in our selection process.

The major factors in evaluating active managers should include:

1. Active return potential. An important question to answer is the degree to which picking winners will help the portfolio. We’ve observed advisors going to extreme efforts to try to identify the best manager in a given asset class. To us, that effort only makes sense if there will be a reasonable payoff for picking a top-performing investment.

Taking on additional cost and tax impact may not make sense if the added return is small relative to the return expected from an average-performing fund or an index fund. We evaluated the active return potential by reviewing the spread between success and failure among fund managers as defined by the performance spread between the top quartile (25th percentile) and the bottom quartile (75th percentile), as well as performance comparisons between active and index returns.

Where’s the Performance Potential?This criterion helps identify whether the cost and risk of active management is worth it. The broader the spread between the top performers and the index or bottom performers, the higher the potential payoff from active management (see Figure 1).

Riding High in April; Shot Down in May2. Repeatability of outperformance. It’s an unfortunate fact of life in the investment industry that many of today’s top-performing funds are tomorrow’s bottom performers. The more random that performance success appears to be, we think the lower the odds of being able to pick a manager who thrives over time. We evaluate the persistence of success by examining the percentage of top quartile managers in one market cycle who stay in the top quartile for the subsequent market cycle (see Figure 2).

3. Batting average relative to the index. We also evaluated the ease with which managers can beat the index by examining the percentage of funds that do so. The batting average follows our thinking about repeatability.

Their Batting AverageFindings indicate that few managers beat the index and that an even smaller number of the outperformers who sustain their outperformance favor index approaches for that asset class (see Figure 3).

Looking Ahead

Although we are largely influenced by empirical data in our investment process, we think it prudent to augment the data with forward-looking judgments about each asset class. The primary factors we assess are:

1. Changes in expectations. The market is a remarkably adaptive organism. Over our investment careers we’ve experienced dramatic changes, seeing once-sleepy sectors such as financial services become among the most diverse and volatile of sectors, while also seeing country dynamics change radically as European equity and bond markets converged following the formation of the European Economic and Monetary Union, then splintered during the sovereign debt crisis.

In Search of EfficiencyWe review changes in market expectations for each asset class, assessing catalysts that will make the asset class more or less efficient and determining whether there are observed or projected changes in return potential, correlation or volatility (see Figure 4).

2. Index changes. Indexes also evolve over time and may be more or less representative of the asset class for investment. We review changes that may influence index performance and portfolio fit, such as privatization, growth or decline in number of constituents, and changes in index concentration.

3. Portfolio role. Often lost in the investment process is the role that the asset class investment is supposed to play in the portfolio. A portfolio is like a sports team or an orchestra—if well-designed, a portfolio can be greater than the sum of its parts. If poorly designed, disaster can ensue. We pay careful attention to the role that the investment is designed to play in the broader portfolio and to how well the index is aligned with the desired capitalization profile, style profile, country exposure or credit exposure.

Active/Passive: Current Positioning

Current Positioning Active Versus Passive Management in Asset ClassesThe positioning of Advisor Partners’ asset allocation models follows the conclusions derived from our empirical research reasonably closely (see Figure 5). Empirical factors favor index funds in the large capitalization equity category, as actively managed large-cap funds in both the United States and in developed international markets have a tough time beating indexes. When they do win, the payoff is rarely worth the incremental risk, cost and tax impact. In addition, today’s winners aren’t necessarily tomorrow’s winners.

Less intuitively, we observe much of the same phenomenon with small-cap U.S. stocks and emerging markets stocks. Most funds fail to beat the index, and winners have a tough time repeating their success. We, however, think that small-cap value strategies can offer some risk enhancement to a portfolio, providing downside protection and margin of safety in certain market environments. Consequently, we use active funds to supplement our core position in a small-cap index ETF. We recently came to the same conclusion, albeit for different reasons, in our positioning for emerging markets stocks. The major emerging markets indexes are unbalanced, featuring significant concentration in commodity and financial stocks. Looking forward, we see the greatest opportunities in smaller companies in less mature sectors within emerging economies. Consequently, we use a mix of active and passive investments.

Fixed income presents some interesting challenges, some of which are transitory in nature. Certain fixed income categories favor active managers, with winners justifying their fees and demonstrating some ability to repeat their winning strategies. In other categories, such as high yield, historical data favors index strategies, but shortcomings in index construction make actively managed strategies suitable alternatives from a risk management perspective.

Why Advisors Should Care About an Active/Passive Blend

We’re often asked why we think this topic is important. In our opinion, we think that all-active and all-index approaches have serious potential flaws.

Strategies that exclusively employ active investments are typically more expensive, tax inefficient and may be more volatile than index-oriented strategies. Although approaches that exclusively utilize index ETFs are increasingly in vogue, we think there are limitations to the all-index approach taken by ETF strategists. All-index approaches forgo the potential return enhancement provided by active managers in certain asset classes, while also diluting the impact of diversifying investments in asset classes that aren’t effectively represented by an index.

We think the framework discussed in this article provides justification for the blended approach while outlining a roadmap for taking considerable subjectivity out of the decision-making process.