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.