Active/passive combinations

Low-cost passively managed investments typically reflect the risk and return characteristics of a given market segment but do not offer the opportunity for outperformance. Combining low-cost active funds and ETFs with index-based ETFs can achieve a balance between the two approaches.

Core-satellite approach

One way to do this is with a "core-satellite" strategy that employs indexing at the core of a portfolio and actively managed funds as satellites. This idea recognizes the differences between indexing and active management and combines the best aspects of both approaches.

The index core provides a risk-controlled, low-cost way to capture market returns (beta) over the long-term, while the actively managed satellites provide an opportunity for market outperformance (alpha).

Active approach	Index approach
Seeks to outperform Higher costs Higher manager risk Shorter-term focus Lower potential tax efficiency	Seeks market return Lower costs Lower manager risk Long-term focus Higher potential tax efficiency

Core-satellite methodology

The conventional view of core-satellite methodology (Figure 1) suggests that it’s prudent to use index funds for markets that are deemed efficient, such as large-cap stocks. This view holds that actively managed funds make more sense to use in areas of the market that are considered to be inefficient, such as small-cap or emerging market stocks. The thinking here is that active managers are more likely to succeed in these areas.

 

Figure 1

_{Source: Vanguard. This hypothetical investment or portfolio strategy is shown for illustrative purposes only and shall not be construed as a recommendation to buy or sell any security or financial instrument, or an offer or recommendation to participate in any particular trading or investment strategy.}

An alternative view of core-satellite investing (Figure 2) suggests that indexing is a powerful investment strategy in all market segments. As a result, the active/index decision should be predicated on an investor’s ability to identify low-cost, talented managers, not on the indiscriminate selection of active managers in apparently inefficient market areas. This view holds that skill in selecting active managers drives the success of a core-satellite portfolio.

 

Figure 2

_{Source: Vanguard. This hypothetical investment or portfolio strategy is shown for illustrative purposes only and shall not be construed as a recommendation to buy or sell any security or financial instrument, or an offer or recommendation to participate in any particular trading or investment strategy.}

Points to consider

• There is no guarantee that a combined active/passive approach will be less risky than an all-active or all-index approach and will achieve comparable returns.
• Whether they choose active or passive funds, investors should consider funds that have low overall costs to increase the probability of long-term success. Costs directly detract from investment returns.