The active vs. index debate is over: Guess who won?

The debate over active versus passive has become moot. The better conversation is about how to get the outcome you want at the best value.

When I’m out to dinner with friends I like to stir up debate with the question: “Which is better, active or index management?” Unfortunately, most of my friends are not in finance, so I usually just get a lot of funny looks.  But get a bunch of portfolio managers and advisors around a table and that question is a great conversation starter.

Inevitably, zealots emerge on both sides of the discussion.  Advocates of active management point to maximizing alpha opportunities in the marketplace, and in the extreme paint index investors as communists. Indexing champions point to the spotty track record of active managers in many asset classes and the high level of fees.

What is missing in this firestorm of words (if not globs of food, and sometimes cutlery), is that neither investment style is always superior. Sometime active is better, and sometimes indexing is. More to the point, it’s a false distinction: all investing is at its core an active decision. How do investors build their portfolios?  Which asset classes do they select, and in what weights? What funds do they choose to invest in? Each of these decisions is active, and requires discretion and insight.  Even if that investor ends up with an all-index portfolio, he or she needed to make a series of active decisions to select that portfolio.

Room for everyone

So if our decisions are active, what do we mean by “active” funds? At BlackRock we describe traditional active funds as “alpha-seeking,” because the term better describes the manager’s objective, which is to exceed the return of a benchmark. And yet, choosing that manager is difficult: In most markets, alpha-seeking funds generally under-perform market cap-weighted benchmarks after fees and taxes. This is true even in fixed income.

All of this may leave many investors….confused.  How should they build the right portfolio to meet their investment goals? Once an investor understands that no one approach is always best, it becomes apparent that the answer is most likely a combination—a blend of index and active funds that fit with the investor’s needs and objectives.

There’s a third leg to this stool, which is the role of factor strategies. Factor funds, sometimes called “smart beta,” generally employ a set of rules to create a portfolio that captures a specific market opportunity or pursue a specific outcome. For example, in the equity market there are funds that provide exposure to momentum or value stocks. In fixed income, many funds use a combination of factors to achieve an outcome, such as blending value and quality insights to design a corporate bond portfolio that has yield characteristics similar to the broad market, but is less exposed to issuers that are likely to default.

icon-pointer.svg Read more about building with factors.

Putting it all together

Given that we now have three investment styles to work with, the question is which to use for what.  Investors should focus on the strength of each style, and combine them as needed.  For example, low-cost, tax-efficient broad market ETFs can be used for core asset allocation and can help keep overall portfolio fees and realized capital gains low, as ETFs are generally tax efficient. Factor funds can be added to access specific markets or strategies that can’t be obtained by traditional indexing, but are generally available at a lower fee than alpha-seeking strategies.  And alpha seeking funds offer the potential to take advantage of unique market opportunities and deliver true out-performance.

classifying returns

Overall, the key for investors is to switch from “OR” to “AND”—index AND alpha seeking AND factors.  This is what the revolution in indexing and factors has brought to investors. It has given all of us better tools to build efficient portfolios. Investors can now be more precise in picking the right investment style for each segment of their portfolio, with overall lower fees and better tax efficiency, without giving up the opportunity for upside.  “AND” helps build a better portfolio. “OR” may just leave you fighting at the table.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.

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