Active or Passive Strategies: How to Choose?

Question: I'm trying to decide whether to opt for actively managed mutual funds like  PIMCO Total Return (PTTRX) and  Vanguard Wellington (VWELX) or stick with index funds and exchange-traded funds and call it a day. Thoughts?

Answer: It's one of the most important--maybe even the most important question--in the fund world. But while partisans make compelling cases for both approaches, Morningstar has long stayed agnostic on the question. For one thing, the data about active versus passive fund performance aren't as clear-cut as extremists on either side of the debate might have you believe. It's true that active managers, in aggregate and over long periods of time, haven't made a strong case for themselves versus market benchmarks; many active funds don't help their own causes because they're too darn expensive. But nor do active funds' lackluster average returns mean that one couldn't possibly choose an active fund that will outperform.

We've also seen firsthand that investors can achieve success (which I define as reaching their financial goals) using either approach, or by blending the two. Using an all-index portfolio is a low-cost, low-maintenance way to go, provided you opt for cheap, broadly diversified index funds and don't speculate with narrowly focused or leveraged vehicles. Meanwhile, we've known many investors who have reached their financial goals by buying and holding fine active funds such as  Sequoia (SEQUX),  Harbor International (HAINX), and PIMCO Total Return; the key to their success was doing their homework on the front end and having the discipline to stick with their active managers through the inevitable rough patches.

A key aspect of making either an active or a passive strategy work for you is to establish what you value in an investment. Here's a quick review of some of the key attributes investors often seek as well as how index and active funds deliver on each.

Low Expenses
Although not all index funds and ETFs have low costs (looking at you, newfangled, high-cost ETFs) and not all active products are pricey (think actively managed funds from Vanguard and Dodge & Cox), expenses on passively managed products are generally lower than active funds'. That expense advantage is a big reason that broad-market index funds have delivered solid returns versus market benchmarks over long periods of time; it's a gift that keeps on giving. The typical no-load, large-blend fund in Morningstar's database has an expense ratio of 1.05%, whereas large-blend index funds charge an average of 0.34% per year, and many charge less than that.

Simplicity/Ease of Use
Looking to build a minimalist, low-maintenance portfolio? It's simple to do so by arriving at your target asset-allocation mix, then populating it with just a handful of broad-market-tracking index funds or ETFs. In contrast, by mixing and matching actively managed funds, you may end up with overlap, and it can be difficult to maintain tight control over your portfolio's asset allocation. Index-fund investors also don't have to worry about operational issues such as manager departures.

That said, it's also possible to build a fairly simple, low-fuss portfolio using just a handful of active funds. The keys to doing so successfully include making sure you understand the manager's strategy, sticking with vehicles that give you a lot of diversification in a single shot, and stacking the deck in your favor by opting for active funds with low costs. If you don't have time to monitor your portfolio on a regular basis (say, every six months or so), you're seeking style purity, or you know you can't put up with periodic bouts of underperformance, stick with index funds.

Tax Efficiency
Although index funds and ETFs aren't universally tax-efficient (bond index-fund investors will owe taxes on their income just as active bond-fund owners would, and some ETFs have socked their investors with big tax bills), broad stock market-tracking vehicles have tended to be pretty tax-efficient over time. Because active fund managers might trade more often, there's a greater likelihood that an active fund will pass taxable capital gains on to its shareholders. ETFs are also structured in a way that makes them tax-friendly. That said, active funds aren't inherently a bad bet from a tax standpoint. Some ultra-low-turnover funds, such as  Jensen (JENSX) and  Dreyfus Appreciation (DGAGX), have done a good job of limiting taxable capital gains payouts. Tax-managed funds, many of which are indexlike but actively managed to reduce the tax collector's cut, have been even better bets for taxable accounts.

Ability to Outperform the Market
Index funds have, on average, delivered fine returns for their shareholders, with the majority topping their category peers', sometimes by wide margins, over short and long time frames. That's a huge selling point. But if you're hung up on "beating the market" (setting aside the important question of whether that's a good or bad idea), you won't get there with index funds. If an index fund is properly tracking its benchmark, the return you receive will be the benchmark's return with fewer expenses--no more, no less. Active funds, by contrast, offer at least the prospect of beating the market. That said, you need to be honest about your own abilities as a fund-picker. Ask yourself how well have you chosen active funds in the past and what's your record of sticking with them. 

Ability to Adjust to Changing Market Conditions
One of the key potential benefits of an active approach is that a manager usually has the latitude to make changes based on market conditions. For example, he might decide to hold cash because stocks look expensive and he can't find things to buy, thereby protecting investors if stocks sell off. Alternatively, a manager could take advantage of weak markets to load up on beaten-down securities that short-term investors have discarded. If an index-fund investor wishes to be opportunistic, meanwhile, she'll have to do it herself.

Investors should bear a few caveats in mind before embracing an active fund for its flexibility and opportunism, however. The first is that many active managers might not be all that active. As I noted in this article, many hew closely to their benchmarks, stay fully invested, and heavily favor their benchmark's biggest constituents. The second is that even though flexible, even tactical, strategies are currently in vogue, managers have demonstrated varying skill in employing them, as Morningstar's Jeff Ptak discusses in this article. Finally, it's worth noting that index-fund investors can easily add an element of active management to their portfolios by periodically rebalancing their portfolios.

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