Core and Explore

ACTIVELY MANAGED FUNDS or index funds? Some investors opt for “all of the above.” They build a core position in index funds, thus ensuring that part of their money captures the market’s return, and then enhance it with actively managed funds in hopes of goosing performance. For instance, once you’ve settled on your target investment mix, you might build two parallel portfolios, one entirely of index funds and the other with active funds.

Alternatively, you might use, say, 80% of your savings to build your target portfolio using index funds and then invest the other 20% in actively managed funds that seem most promising. There’s an intriguing argument for this second approach.

Financial experts often refer to alpha and beta. Beta is the market’s return. Alpha is any incremental return, over and above that of the market. When you buy index funds, all you get is beta—the market’s return—but you get it at low cost. By contrast, with actively managed funds, you get a lot of beta, plus (you hope) some positive alpha. Problem is, these actively managed funds have high expenses, and yet much of that cost is simply buying you beta. The upshot: Why not use index funds to capture the market’s return at low cost, and then seek alpha with a handful of funds that either focus on promising market sectors or that are run by talented managers who own a relatively modest number of stocks? That way, you have a limited amount of money in higher cost funds and it’s buying you more of a pure bet on alpha.

Some investors take a third approach: They view the market for blue-chip U.S. stocks as highly efficient, so they index that portion of their portfolio using, say, an S&P 500-index fund. Meanwhile, these investors figure smaller U.S. stocks and foreign markets are less efficiently priced, so an active manager has a better shot at generating market-beating returns.

The latter argument is a little dubious: The reason small stocks and foreign markets may be less efficiently priced is because it’s more expensive to trade these shares—and thus trying to exploit the inefficiencies may not be worth the trading costs involved. Moreover, actively managed funds that focus on smaller U.S. shares and foreign markets tend to charge higher annual expenses. Those high expenses also make it harder to earn market-beating returns.

Next: Index Fund Managers

Previous: Why Funds Falter

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