Insights

10 Strategies for Combining Active & Passive Investments


More art than science

Although the polarizing active versus passive management debate persists, more sophisticated investors have found that the real question is not whether to choose active or passive strategies, but how to combine the best of both approaches in a holistic way to seek the most beneficial portfolios for clients.

This newfound middle ground hinges on a new definition of what it means to be an active investor.

While historically, active management referred to individual security selection, today, with an unprecedented number of investment tools at their disposal, investors seek alpha at the asset class, country, sector or even industry level. Furthermore, smart beta strategies that offer a hybrid path — blending the alpha-generating potential of active management with the low cost of passive approaches — have gained a following.

How you combine active and passive strategies for your clients depends on everything from your market outlook to your investing philosophy. Other factors that may drive your decision to use one strategy over another include sensitivity to fees, diversification, and the pursuit of alpha maximization.

Figure 1: The Definition of “Active Investing” Is Changing

Here we share ideas for combining active and passive strategies that we have seen implemented by our financial advisor and institutional clients.

Fee reduction and tax efficiency

Investors seeking to minimize fees and tax liabilities may consider emphasizing index products.

Strategy 1: Passive Core Plus Active Style Boxes

Use passive strategies in the “core” and active managers in the growth and value styles.

Strategy 2: Combine Active and Passive in Each Style Box

Split the difference in each style box between active and passive, providing an opportunity to reduce fees while continuing to seek alpha.

Strategy 3: Passive Core, Active in Alternatives

Be “active in alternatives” to augment a passive equity and bond core.

Strategy 4: Multifactor Smart Beta Core, Single-Factor Satellite

Replace active managers with smart beta strategies, but gain access to factors that active managers target and save on fees.

Diversification

Index investments may provide increased diversification to portfolios concentrated in a small number of individual stocks, or they may be used to round out a fixed income exposure.

Strategy 5: Core-Plus Fixed Income Allocation

Create flexibility in the core for diversification, stability and income and select active managers with expertise in less efficient sectors to add additional diversification.

Strategy 6: Individual Large-Cap Stocks with Passive Complements

Purchase individual stocks in the large-cap space based on defined screens, e.g., income, growth, etc., but use indexes for asset classes that are more difficult to analyze, such as small caps and emerging markets.

Alpha maximization

The pursuit of alpha maximization may be achieved by mixing active and passive investments based on market efficiency and managers’ historical ability to generate alpha in the asset class.

Strategy 7: Multi-Asset Class Active Core, Passive Satellites

Use passive exposure to manage traditional asset classes with a tactical, multi-asset-class core holding.

Strategy 8: Equity Core Plus Sector Rotation

Use a passive holding as the core of the allocation and pursue alpha through active country, sector or industry rotation.

Strategy 9: Focus on When to Be Active, Not Whether

Choose to be active when the conditions are right or when an asset class is potentially mispriced.

Strategy 10: Passive/Active Mix by Efficiency of Asset Class

Identify not only whether to be active in an asset class, but also how to be active in each.

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