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Investing Specialists

Index, Active, or Both: 8 Questions to Help You Decide

A user's guide to customizing your ratio of active and passive investments.


Note: This article is part of Morningstar's April 2015 Active, Passive, and In-Between special report.

Morningstar's analyst team has long held the view that investors can assemble successful portfolios composed exclusively of index funds, entirely of actively managed funds, or a combination of the two. Just how much they shade their portfolios in one direction or another depends on their personal characteristics: the type of account they're investing in, how many holdings they'd like to maintain, and how much oversight they'd like to provide for their portfolios on an ongoing basis, among other factors. 

As you think through your own portfolio's allocations to active and passive management (and I would put individual-stock investments under the "active management" umbrella), ask yourself the following questions. 

Question 1: How big a concern is tax efficiency?
Major concern/investing in taxable account: Favor equity index funds.
Not a concern/investing primarily in tax-sheltered accounts:
Favor either active or index funds.
If you're investing in a taxable account, broad-market index funds or exchange-traded funds will tend to be a better fit for your portfolio's equity exposure than will actively managed products. That's because broad-market index funds and ETFs have low turnover; exchange-traded funds have the added benefit of being able to meet the redemptions of large investors by handing them stock (rather than having to sell the stocks and potentially realizing capital gains).

Actively managed equity funds, by contrast, usually have higher turnover, and more-frequent selling can translate into more-frequent capital gains distributions. Many equity funds made very large capital gains distributions in 2014, for example. Of course, tax efficiency is a non-issue if you're investing in a tax-sheltered account such as an IRA or your company retirement plan: A fund can make capital gains distributions every day and you still won't owe taxes on them. You'll just owe taxes when you sell, in the case of traditional IRAs and company retirement plans. 

Also, bear in mind that even though ETFs and index funds are more tax-efficient in the equity space, the index/ETF format confers no special tax-efficiency advantages in the realm of bond funds. Instead, bond funds must pay out the income to shareholders of bond ETFs, index funds, and actively managed funds on an ongoing basis, and shareholders in taxable accounts will owe tax on that income. The only way to dodge a tax bill on ordinary-income distributions is to stash the bond fund inside of a tax-sheltered account or, if you want to hold bonds in your taxable account, hold municipal bonds, whose income is typically free of federal and, in some cases, state income taxes.

Question 2: Do you aim to beat the market or are you content to match its return, less investment costs?
Aim to beat the market: Favor active funds.
Content to match it, less costs: Favor index funds.
It's an open question whether you'll be able to do so, but if you're determined to beat the market--either on the basis of raw returns or risk-adjusted returns--you have no choice but to invest in actively managed funds (or actively manage your own portfolio of individual securities). 

Just be aware that beating the market sounds easier than it is. Not only do active equity funds, in aggregate, have an underwhelming track record of beating appropriate benchmarks, but investors don't always fully benefit when they do because they've jumped in and out at inopportune times. (Actively managed international-equity and bond funds have a better track record of beating commonly used benchmarks, in part, because they don't look a lot like their benchmarks, as discussed in this video.) From that standpoint, accepting the market's return, less expenses--as index-fund investors do--isn't as underwhelming of an investment approach as it might first appear.

Question 3: Is risk control a key consideration?
Yes: Favor active funds that emphasize downside protection.
No: Favor index funds.
The longer I've focused on investing, the more I've come to conclude that one of the key virtues of active strategies is the ability to control risk. It's something that many of the best, most thoughtful managers are able to excel at. Because active managers can build cash or avoid overheated market segments, they have the potential to keep volatility down relative to index products that have no such latitude. Not only do relatively strong returns in down markets mean that defensive active managers have less ground to make up in rallies, but Morningstar data have tended to show that lower-volatility strategies do a better job of keeping investors in their seats. 

Of course, it's worth noting that many active managers don't take advantage of such defensive techniques, so don't assume that active management equates to good downside protection. Indeed, active equity funds did not, in aggregate, deliver notably smaller losses than the market during the 2008 downturn. That said, Morningstar's medalist funds feature a large complement of defensively minded offerings, because of the very benefits outlined above. 

Question 4: How good is your track record?
Have had much success with manager selection and/or individual-security selection: Favor active strategies.
Minimal or poor past track record of manager selection and/or individual-security selection: Favor index funds.
Be honest: If you've relied on active management in the past--either actively managed funds or your own individual-security selections--how successful have you been? Compare your portfolio's return relative to a blended benchmark that matches your own asset allocation, as outlined here. If it turns out that you haven't added value by selecting and maintaining active managers or picking individual securities, you're better off steering all or part of your portfolio to index funds. 

And even if you have had great success with an actively managed portfolio, you may still want to consider adding a slice of index exposure. Not only does broad-market exposure tend to improve the risk/reward characteristics of the total portfolio, but adding additional diversification may make you more likely to stick with your actively managed holdings when they encounter a downturn. 

Question 5: How patient are you/how much can you live with big performance swings versus a market benchmark?
Not very patient: Favor index funds. 
Very patient: Favor active funds.
Several of the previous points have hinted at the role of behavior in all of this. To perform better than a broad-market index and/or a peer group, an active fund or strategy has to be appreciably different from its benchmark and/or its peers. High-conviction, idiosyncratic strategies have the potential to deliver market-beating performance over long periods of time, but they can also lead to sustained bouts of underperformance relative to a peer group or index. Thus, even if a fund manages to best its peers or its benchmark, investors may not capture that success if they abandon it during performance troughs. Index funds don't always perform well, to be sure, but the index fund investor can at least take comfort in knowing that she's not performing much worse than the market at any given point in time. 

Here's another area where reflecting on your own past behavior--or better yet, using a personalized benchmark to assess your track record in selecting and sticking with active managers--can help determine whether you're a good fit for active management or whether you're better off sticking with index funds, which might be easier to own.

Question 6: How much portfolio oversight do you care to provide on an ongoing basis?
Limited oversight: Favor index funds.
Some oversight: Favor either active or index funds.
From an ease-of-use standpoint, broad-market index funds have it all over actively managed products. It takes much less effort to analyze index funds than active--costs and index construction are the two keys, whereas the prospective active-fund investor must consider softer factors such as management, strategy, and stewardship. Index funds will also tend to be easier to oversee on an ongoing basis, and rebalancing an all-index portfolio is a cinch. Those limited oversight responsibilities are a key reason I often urge retired investors--especially older retirees who don't have the time or inclination to be very hands-on with their portfolios--to consider a streamlined, index-centric portfolio.

Question 7: Is a streamlined portfolio a goal?
Yes: Favor index funds.
No: Favor active funds.
In a related vein, index funds can make good sense for portfolio minimalists. By buying total-market index funds--one for U.S. stocks, one for foreign stocks, and one for bonds--investors can gain exposure to a huge swath of securities in three highly economical packages. Indexers can skinny down their portfolios even more by using index-based balanced funds or world-stock funds.

Meanwhile, it might take a few more holdings to build an active portfolio that's truly diversified, though it's not impossible. Morningstar's various allocation categories feature many fine active funds that could easily be used as core or standalone holdings.

Question 8: How concerned are you with precision?
Very concerned: Favor index funds.
Not all that concerned: Favor active funds.
Another area to consider is how tightly you'd like your investments to focus on a given part of the market. Do you want your equity fund to always stay fully invested and never hold cash? Do you want your bond fund to always focus on investment-grade bonds from U.S. issuers? Index funds are typically "pure plays" on a given market segment, making them a good fit for investors who would like to exert precise control over their portfolios' exposures. 

Of course, there are also active funds that tend to deliver fairly pure exposure to specific market segments;  T. Rowe Price Mid-Cap Growth (RPMGX) is a good example of a fund that has generally hewed closely to its namesake stocks, as evidenced by its style map. It's also worth noting that being free-ranging can be a positive at times. Investors have generally been embracing active bond funds, for example, no doubt because they'd like their managers to have the latitude to venture beyond the government-bond-heavy profile of the Barclays U.S. Aggregate Bond Index.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.