Instead of choosing between index and active investing, consider the core-satellite approach wherein the best aspects of both strategies are combined to construct a portfolio.

If there's one investment lesson to be learned from the pandemic, it's that short term market movements are truly unpredictable.

This uncertainty is understandably not very comforting for many. Google trends reveal that the demand for market information tripled as COVID hit this time last year. The great investors of our time – Warren Buffet, Ray Dalio, Bill Ackman – all saw an increase in search engine interest as investors flocked to them for guidance. The search phrase 'what stocks should I buy?' reached peak popularity in March 2020, as did the phrase 'active vs index'.

The latter in particular has in recent times been widely debated. On average, active management has unperformed over the last three decades when compared to its index counterpart. And while active managers can more easily adjust portfolios and minimise losses when markets tumble, it's not guaranteed that they'll always re-enter at the opportune time. This was evidenced by the fact that many active managers missed the market rebound last year, for it happened almost as quickly as it fell.

Yet despite such factors, over 70 per cent of assets in Australia are still actively managed, perhaps due to investor conviction that they'll fare better or a preference for having a professional make the decisions (hence the aforementioned search interest).

So why is there still a place for actively managed funds within a portfolio when their consistent outperformance is a perennial challenge? How then should investors choose between active and index investing? Do investors need to choose between one strategy and the other?

The answer to this is that there is benefit in both strategies if the conditions are right, and if used together in what Vanguard terms the core-satellite approach where index funds are complemented with actively managed funds, can be even more advantageous.

Fundamentally, choosing index, active, or a combination of both investments is not a security selection question, but an asset allocation one. It's about determining the appropriate balance according to individual goals, risk tolerances, time horizons and return requirements, and not about pitting index against active.

It's also about whether or not the investor has the resources necessary to identify outperforming managers if they choose to use, be that through their own research or expertise, or when working with a trusted partner like a financial adviser.

According to Vanguard research, investors should consider four variables when selecting an index, active or combination approach that take the arbitrary out of the decision-making process. They are: expected active alpha, cost of active management, potential for underperformance and the individual's tolerance to that underperformance should it occur.

Once investors determine their level of comfort with the characteristics of active management, they can then decide on how much of their portfolio to allocate to actively managed funds, and how much to index funds.

The core-satellite concept recognises the fundamental differences between the two and combines the best aspects of both approaches to construct a portfolio.

Index funds can be used to form the stable "core" of the portfolio because they are lower cost, diversified and provide more consistent performance.

In this instance, active funds are then used as "satellites" for an opportunity to outperform the market and achieve higher returns, or to adopt style-driven strategies.

At the end of the day however, a thoughtfully considered asset allocation can only yield favourable results if it is engrained in patience and discipline. Short-term market conditions may make headlines and dominate search engine data, but it's the long-term story that is most important.

An iteration of this article was first published in the Australian Financial Review on 12 April 2021.
 

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