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The Best of Both Worlds: Combining Active and Passive Fund Investing for Optimal Allocation

Updated: Nov 5, 2023

State of the Industry series: Asset Allocator Talk II: Active vs. Passive Fund Selection

Active fund selection, which entails choosing individual investment funds with the objective of outperforming the market, presents its own set of challenges. The reality is that most active funds struggle to consistently beat the market. Nevertheless, it is essential to recognize that active funds can play a valuable role in asset allocation strategies and portfolio construction, particularly under specific market conditions.

Active funds face a formidable challenge in consistently outperforming the market. This challenge is often attributed to the high level of market efficiency, which restricts opportunities for exploitation. Some argue that even in an efficient market, active funds would still achieve a relatively balanced distribution of both outperformance and underperformance, resulting in a success rate of approximately 50%. However, there are several factors that can impact the actual odds of active funds beating the market. Constraints like liquidity and regulatory requirements, as well as the influence of behavioural biases exhibited by fund managers, can significantly affect the likelihood of active funds achieving market-beating performance.

Passive vs. Active Fund Investing: Which is Right?

Active and passive investing offer distinct advantages and drawbacks. Active investing aims to outperform the market through individual fund selection, but it comes with higher costs and risks. On the other hand, passive investing involves investing in index funds that mirror market indices, offering lower costs and risks but potentially limited returns. The right choice depends on factors like investment goals, time horizon, and risk tolerance, and market conditions also play a significant role.

During high market volatility, active investing becomes more challenging due to the need for timely and accurate decisions. Conversely, passive investing benefits from stable market conditions and long-term trends without frequent adjustments. In periods of economic growth, increased capital flows can drive up stock prices, posing challenges for passive funds. However, active fund managers may identify undervalued stocks with potential outperformance. Low-interest rates raise costs for passive bond investments, resulting in lower returns. Active managers, on the other hand, can identify bonds with higher yields and the potential for outperformance

The Best of Active Fund Investing

Active fund managers have the ability to utilize various investment strategies, such as value investing, growth investing, or momentum investing, with the aim of achieving superior returns compared to passive investing. However, extensive research consistently demonstrates that the majority of active funds fail to outperform the market over the long term. Consequently, active funds may be more suitable for shorter to mid-term investment horizons when implemented within a core-satellite portfolio strategy.

There are specific environments and conditions that justify the inclusion of active fund selection within a portfolio.

  1. Market inefficiencies: Active managers can identify and capitalize on undervalued sectors or stocks during market volatility, potentially leading to outperformance.

  2. Economic transitions: Active managers can navigate changing market dynamics and select investments aligned with emerging trends or growing sectors during economic shifts.

  3. Unique investment opportunities: Active managers can invest in specialized or niche assets not well represented in passive index funds, offering exposure to distinct investment opportunities.

  4. Active risk management: Active managers can adjust investment allocations and holdings based on risk assessments, potentially mitigating downside risks during volatile market conditions.

Active fund selection also enables customization based on individual preferences, risk appetite, and investment goals, allowing for a tailored portfolio approach. This level of personalization provides investors with greater control over their investment decisions, enabling them to align strategies with their specific needs and objectives

The Best of Passive Fund Investing

The ability of passive funds to replicate market indices and provide broad market exposure makes them an attractive option for achieving diversification and maintaining a well-balanced portfolio. By incorporating passive funds into their portfolios, investors can efficiently allocate across various asset classes and sectors, optimizing risk-adjusted returns. Additionally, passive funds offer an inherent risk reduction element compared to active investing. Through diversification, index funds spread investments across multiple companies and sectors, thereby mitigating the potential impact of risks associated with any single entity or industry.

In situations where stability and market consistency are crucial, passive fund investing is often the more suitable approach. This holds particularly true in market conditions characterized by a sideways market, volatile market, efficient markets, stable markets, and liquid markets. In such situations, passive investing proves to be a more favourable strategy for maximizing returns and maintaining lower investment costs

Combining Passive and Active Fund Investing

Investors can benefit from a combined approach of passive and active investing styles instead of exclusively choosing one over the other. By incorporating both strategies within a core-satellite allocation framework, investors can construct a well-rounded portfolio that aligns with their individual circumstances and goals. This approach enhances portfolio resilience and performance, regardless of the prevailing market conditions.

One effective approach to achieving this combination is through strategic asset allocation. This entails dividing the portfolio into various asset classes such as stocks, bonds, alternatives and cash. Within each asset class, investors can opt for either passive or active funds based on their preferences and investment objectives.

Another effective approach to consider is tactical asset allocation. This strategy involves making adjustments to the portfolio's asset allocation based on changes in the market. By using active funds, investors can strategically overweight or underweight specific asset classes based on their outlook for the market and the potential opportunities they anticipate. This flexibility allows investors to actively respond to market conditions and potentially capitalize on favourable trends or mitigate risks.

By implementing a blend of passive and active investing approaches through strategic and tactical asset allocation, investors can harness the benefits of both strategies and create a well-diversified portfolio tailored to their specific risk profiles, needs and goals.

Finding the Right Mix

Determining the optimal portfolio mix of passive and active funds is not governed by strict rules. It depends on factors such as the investor's risk tolerance and time horizon. Each investor has unique circumstances and goals that shape their ideal mix of funds.

Investors with higher risk tolerance and a longer time horizon may allocate a larger portion of their portfolio to active funds. Active investing carries higher risks but also offers the potential for higher long-term returns.

Conversely, investors with a lower risk tolerance or a shorter time horizon may lean towards a larger allocation to passive funds. Passive investing provides stability, lower costs, and broad market exposure, making it suitable for those seeking more conservative or short-term investment strategies.

By tailoring a passive-active investment mix, investors can create a well-rounded portfolio that optimizes the advantages of both investing styles. This approach increases the potential for long-term investment success by constructing a diversified and flexible portfolio within a strategic asset allocation framework. It allows investors to benefit from the stability and lower costs associated with passive investing while having the opportunity to capture potential outperformance through active fund selection.

Striking the right balance between passive and active funds is key to creating a portfolio that aligns with specific needs, goals, and risk tolerance. This tailored approach enhances the chances of long-term investment success.

In conclusion,

The debate between active and passive fund selection is ongoing, and there is no one-size-fits-all approach. However, by considering individual circumstances, goals, risk tolerance, and time horizons, investors can determine the optimal mix of active and passive funds for their portfolios.

The core-satellite approach provides a valuable framework for implementing this mix. By combining passive funds as the core holdings, which provide stability, broad market exposure, and lower costs, with active funds as satellite holdings, which offer the potential for outperformance and customization, investors can create a well-rounded portfolio. The core-satellite approach offers the best of both worlds harnessing the potential for long-term success.

It is crucial to emphasize that the portfolio mix should be consistently monitored and adapted to align with evolving market dynamics, economic cycles, and individual needs. By integrating active and passive fund selection in a core-satellite approach, investors can aim for a harmonious portfolio that optimizes the opportunities for long-term investment success.


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