Forget Active Vs. Passive: Why Not Own Both Types Of Funds?

Decades of research show the benefits of asset allocation using index funds. But new research suggests that many active strategies outperform over time, even after fees are taken into account.

Asset managers including John Hancock and Morgan Stanley have researched the active vs. passive question, as it's in their interest to determine the optimal return for their clients, balanced with the effect of management fees.

Unfortunately, all too often, that question is answered incorrectly. It's not an either/or proposition; the best long-term results come when you do both.

"Blending active and passive strategies can help investors outperform and pursue other important objectives while still being mindful of cost and tax efficiency," John Hancock analyst Leo M. Zerilli wrote in a white paper.

Active Investing

Active investing means putting your money into funds whose strategy is based upon managers' ability to pick investments deemed to have the potential to appreciate in value. In the past, active vehicles were exclusively the domain of mutual funds, but today it's easy to find actively managed ETFs as well.

In general, active managers strive to beat a particular benchmark. In addition, each fund has its own stated objective or philosophy.

For example, the Growth Fund of America (AGTHX), an active fund with $282.5 billion under management, "seeks opportunities in traditional growth stocks as well as cyclical companies and turnaround situations with significant potential for growth of capital," according to fund literature.

This fund consists mainly of domestic equities. Its benchmark is the S&P 500.

Passive Investing

Passive investors - and this includes many if not most clients of fiduciary financial advisors these days - you don't go through the process of trying to identify mispricings or securities trading at low multiples relative to their earnings.

Your goal is to get market performance, usually based on a broad swath of global indexes, and indexes representing various market caps and sectors. You typically wouldn't just buy an S&P index fund, such as the SPDR S&P 500 ETF (NYSEARCA:SPY) and call it a day. Instead, you just invest in a way that gives you broad market exposure.

However, many passively invested portfolios do consist of a collection of index funds, which is an easy and inexpensive way to generate market returns.

As you might imagine, active management is more costly, since stock-picking requires not only a manager but also research analysts. In addition, the higher frequency of trades adds costs. That's why actively managed funds have higher fees than index funds.

That's one of the arguments index proponents make: The lower fees mean index funds are less expensive, which results in a higher return for account owners. Less money is going out of the fund and into the managers' pockets.

Combining Active And Passive Strategies

Although the active/passive debate tends to cast the two approaches as being on opposite ends of the investing spectrum, more researchers are seeing benefits to combining these.

In practice, many investors own both index and actively managed funds. For example, as an advisor, if a client came in with a taxable account holding actively managed funds, I wouldn't just swap it out for a passive fund if the client had big capital gains. That could result in a big (and unnecessary) tax hit.

It's definitely possible to substitute an active fund for an index fund, if the underlying asset class is the same. For example, you could use an actively managed large-cap domestic fund, such Fidelity Magellan (FMAGX) instead of the S&P 500 index. The Magellan fund has more of a growth tilt, so you'd miss out on some value, but in a pinch, it would be acceptable.

In this environment, with domestic growth leading the market, that swap would work very well.

In a recent blog post, Dan Hunt, senior investment strategist at Morgan Stanley, summed up the advantages of combining active and passive in a more strategic manner.

The Right Fund For The Job

"Active strategies have tended to benefit investors more in certain investing climates, and passive strategies have tended to outperform in others. For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go," Hunt wrote.

He added, "Depending on the opportunity in different sectors of the capital markets, investors may be able to benefit from mixing both passive and active strategies—the best of both worlds, if you will—in a way that leverages these insights. Market conditions change all the time, however, so it often takes an informed eye to decide when and how much to skew toward passive as opposed to active investments."

In other words, despite the debates you'll find all over the Internet, and perhaps in discussions with your financial advisor, there may be good reason to utilize the best instrument to help you achieve your financial goals.