Historically, one of the more common debates in investing has been the question of whether index or active management is ‘superior.’ Some people get caught up in the idea that one or the other is the better way to go, with lots of data thrown in to support their point.
Others vary their view by market, believing for example that an index mutual fund or ETF is better in efficient markets, while an active fund should be used in inefficient markets.
But many investors and financial professionals – myself included – believe that the answer is not one or the other, but rather both. One has only to look at the investments of pensions, endowments, and other institutional investors to see that the practice of combining index and active is fairly common. And the reason for this is simple: index and active investments have different characteristics, and therefore play different roles in a portfolio.
In fact, blending the two together can help investors meet their objectives better than choosing only one or the other. Active funds aim to produce alpha, or outperformance, but do so by taking on more active risk than index funds. Index funds and index-based ETFs are designed to track a benchmark and, therefore, don’t try to outperform their given market. But they can also help manage overall portfolio risk, are generally low cost and tax efficient, and can provide intraday liquidity.
So let’s take a look at an example of how blending active and index can potentially produce a better outcome than just choosing one strategy alone. Below are the risk and return characteristics from the past 5 years for two high yield funds (keep in mind that high yield has historically been a volatile asset class). The first fund is the index-based iShares High Yield Corporate Bond ETF (NYSEArca: HYG) and the second is the median top quartile active manager in the high yield bond space.