Active and passive investment strategies have the potential to complement one another in a diversified portfolio. However, when to use one or the other is a decision investors have to make. To help shed some light on the topic, we came up with the following framework for getting the most out of an opportunity set consisting of both active and passive approaches when constructing a portfolio:
- When an asset class is difficult to replicate or inefficient, an active investment strategy can make sense. For instance, the municipal bond market has many moving parts. Therefore, an active approach may be better suited for taking advantage of market opportunities as they arise.
- Passive investment strategies are typically better suited for shorter-term tactical positions, whereas active strategies are considered to be longer-term holdings. Therefore, when selecting an active manager, you'll want to evaluate their performance over a full investment cycle—which can last several years.
- When the reward, as measured by absolute or risk-adjusted returns, for selecting a top asset class performer is not much greater than that of a bottom performer, a passive investment strategy may make sense—especially since you can benefit from reduced fees and expenses. In this instance, the point is to deploy resources where they will have the most impact.
In Figure 1, the return dispersion between top and bottom quintile performers over the past 10 years was wider for large-cap growth and value than it was for large-cap blend—findings that may be consistent with the practice of using actively managed growth and value managers alongside a passive blend exposure.
In Figure 2, the top to bottom quintile return dispersion in fixed income was wider for nontraditional bonds (unconstrained bonds), convertibles and high yield than it was for intermediate-term bonds—suggesting the latter might be a better candidate for a passive approach than the first three.