Index or active? A four-step framework for deciding the right mix

Although often viewed as a binary, either-or, decision, in fact there is often room for both active and index management styles within a portfolio. The decision point then becomes about the right mix versus a binary choice.

Selecting the right asset class exposures that fits with a client’s risk profile and investment objective – from equities to bonds and everything in between – is an important step in planning for advisers.  What follows is to determine the preferred investment style to deliver on investment goals, whether an index fund or an actively-managed strategy, or a mix of both.  

It may be that an actively-managed strategy improves the chances of meeting an investment goal, whether that is outperforming a benchmark, maximising yield or dampening portfolio volatility, equally an index exposure may suit better for introducing greater diversification, lowering cost and reducing risk in a portfolio. The big question then is how to achieve that Goldilocks scenario of having the mix of index and active just right.  

To make an informed decision, a framework that helps set the proportions of active and index exposure across a given asset class in a portfolio can support advisers in making a disciplined call that will set their clients up for the best chance of success.  

INVESTING IS A ZERO SUM GAME

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The starting premise for this framework is that investing is a zero sum game, in which each fund that outperforms the market does so at the expense of others, which underperform average market returns.  While index managers should deliver close to the market return after costs, active managers will either beat or be beaten by their benchmark.

According to S&P’s SPIVA scorecard of Australian active manager performance for 2018, 83 per cent of Australian-domiciled broad-cap active equity funds underperformed over 10 years, after costs. From this, it is reasonable to conclude that the odds of making a successful choice of active manager can be low – hence the importance of putting rigorous standards in place when deciding how much active and index exposure is appropriate.

EXPECTATIONS AND CONVICTION

The first consideration relates to the level of outperformance expected from the active strategy, and your conviction in the investment manager’s ability to deliver it. Higher conviction in a manager or strategy would warrant a higher allocation to active, whereas lower conviction may indicate a higher allocation to an index strategy. Conviction can be difficult to form, however. When deciding on whether you have confidence in an active manager’s potential to outperform, look to understand characteristics like their investment principles, their security selection process, firm ownership structure and the experience and tenure of their team. 

For instance, looking at Australian small caps, a higher proportion of active managers have tended to outperform the index over time. With this in mind, an investor might opt to have a higher weight to a dedicated active small cap fund if they are comfortable that a particular strategy has a good chance of providing outperformance over a given time period.

THE COST FACTOR

The second consideration is cost, which has a direct impact on the potential for outperformance.  If you don’t have the means to access active management at a low cost compared to your expected outperformance, then a lower level of active may be appropriate. 

Again, the S&P scorecard proves an important point in that it’s calculations on active manager performance are made after fees. Lower fees mean an investor keeps more of their returns, increasing their odds of achieving outperformance. 

ACTIVE RISK & RISK TOLERANCE

The third consideration is the level of active risk that the investment manager is taking, measured by the expected difference in returns both above and below the benchmark. A greater level of active risk may be tempered by a higher allocation to indexing.

Related to the active risk of the manager’s strategy, is your client’s level of tolerance for taking active risk. If they can tolerate a high degree of underperformance without losing their nerve, then a higher weight to active may be appropriate. 

Following the framework of conviction, cost, active risk and risk tolerance to decide on the mix of active and index requires qualitative judgement on the adviser’s part.  But the bottom line is that the motivations for using both forms of management vary.  

Using a decision-based framework to determine the appropriate mix can help advisers consider why they believe a given active or index strategy is right for their individual client’s circumstances, rather than simply making a choice based on how they view an investment strategy on its own merits. 

This framework might not always deliver investors the ‘just right’ combination of index and active in their portfolio, but it can help keep their investment goals at the forefront of their decision-making, ensuring that they choose the right funds or investment strategies for the right reasons. 

Aidan Geysen is Vanguard's head of investment strategy for Australia.