Active-passive combinations

Actively managed investments offer an opportunity for outperformance, but they also bring greater relative risk and unpredictability.

Low-cost passively managed investments typically reflect the risk and return characteristics of a given market segment but do not offer the opportunity for outperformance. Combining low-cost active funds with index-based ETFs can achieve a balance between the two approaches.

 

Core-satellite approach

One way to do this is with a "core-satellite" strategy that employs indexing at the core of a portfolio and actively managed funds as satellites. This idea recognizes the differences between index and active fund management and combines the best aspects of both approaches.

The indexed core provides a risk-controlled, low-cost way to capture market returns (beta) over the long term, while the actively managed satellites provide an opportunity for market outperformance (alpha).

Active approach

• Seeks to outperform
• Higher costs
• Higher manager risk

Index approach

• Seeks market return
• Lower costs
• Lower manager risk

 

Core-satellite methodology

The conventional view of core-satellite methodology (Figure 1) suggests that it's prudent to use index funds for markets that are deemed efficient, such as Canadian large-cap stocks. This view holds that actively managed funds make more sense to use in areas of the market that are considered to be inefficient, such as Canadian small-cap or emerging market stocks. The thinking here is that active managers are more likely to succeed in these areas.

 

Figure 1

Source: Vanguard. This hypothetical investment or portfolio strategy is shown for illustrative purposes only.

 

An alternative view of core-satellite investing (Figure 2) suggests that indexing is a powerful investment strategy in all market segments. As a result, the active/index decision should be predicated on an investor's ability to identify low-cost, talented managers, not on the indiscriminate selection of active managers in apparently inefficient market areas. This view holds that skill in selecting managers drives the success of a core-satellite portfolio.

 

Figure 2

Source: Vanguard. This hypothetical investment or portfolio strategy is shown for illustrative purposes only.

 

Points to consider

• There is no guarantee that a combined active-passive approach will be less risky than an all-active or all-index approach and will achieve comparable returns.
• Whether they choose active or passive funds, investors should consider funds that have low overall costs to increase the probability of long-term success. Costs directly detract from investment returns.