Index-based investing is often seen as a benchmark for active strategies, and rightly so. But what’s easy to overlook is the fact that indexing also represents an investment strategy, one with a particular set of pros and cons that can compliment active strategies.

For investors inclined to blend several strategies, a choice to leave out a passive portfolio from the mix can be needlessly restrictive. But if you see an index strategy as one point on the continuum from passive to the many flavors of active, it becomes one more choice on the spectrum. In effect, indexing can be seen as a particular type of “active” investing.

Just like any active strategy, indexing has a unique set of pros and cons. Pairing indexing with one or more active strategies, in turn, opens up tactical and strategic portfolio-design opportunities that would otherwise remain closed by limiting the choices to active.

These points come to the fore in a new essay by Richard Ennis, the retired chairman of EnnisKnupp, an institutional investment consultant. Writing in The Journal of Portfolio Management, he considers results for pension fund strategies in recent years, including asset allocation decisions to shift into so-called alternative investments and whether the glory days for this corner of markets has passed due to rising market efficiency.

“We propose that institutional trustees place half their portfolio assets in a few broad stock and bond market index funds, thereby sharply reducing their cost of operation and increasing the likelihood of outperforming those among their peers that choose not to follow suit,” he concludes.

As a corollary, we propose that trustees then increase or decrease their passive investment percentage, incrementally but systematically, in the ensuing years, based on the performance of the active assets. In other words, if active investments, net of all costs, underperform a properly constructed, equivalent-risk benchmark over time, trustees would transfer assets to the passive portfolio as a matter of policy. Conversely, to the extent that active investing adds value, moneys could migrate from the passive portfolio to the active one—with justification. In either event, the trustees would be acting systematically on their experience, which is responsible behavior. Over the long run, this procedure will minimize the regret of having pursued the wrong strategy. The initial condition—a 50% passive allocation—reflects the lessons of the financial economics of institutional investing much better than does the status quo. Operationally, the proposal is disciplined, pragmatic, and responsible.

Viewing indexing and active strategies as complimentary isn’t new – core and satellite strategies have been used for years in some corners of money management. But perhaps it’s time to take a fresh look at the two sides of this portfolio-design coin.

The debate about active management hasn’t been resolved, nor will it be. But the sea of research over the past decade on variations of tactical asset allocation, for example, suggest that the case for doing something other than passive is has merit, albeit with risks.

Indexing comes with risks, too, but they tend to be a different set of risks vs. active strategies. To the extent that you can successfully mix the two the decision provides the basis for creating a more robust total portfolio.

Thinking through this idea starts with reviewing indexing’s strengths and weaknesses. The strengths include low fees and results that tend to rank at or moderately above the median for equivalent active strategies. The lack of risk management (beyond a broad beta footprint in the target market) is a weakness, at least it can be during certain periods. Notably, most indexing strategies are subject to relatively steep drawdowns.

The challenge is developing/identifying active strategies that compliment indexing’s shortcomings in a bid to build a better super-strategy. That’s a tough challenge, of course, but for active investors who shun any form of indexing they need to confront a simple question: What’s the case for not exposing your portfolio, at least in part, to a strategy that has an encouraging history of beating most of its peers at a very low cost?

If you’re 100% confident that you can design or identify active strategies that will outperform a relevant index the case for going all-in on active is clear. But in the real world no one has perfect confidence and so diversifying strategy risk, to some degree, with indexing is compelling.

For indexers, on the other hand, the key question: Are you comfortable with the particular risks that passive strategies are likely to dispense through time? For those who are true buy-and-holders and willing and able to sit through deep drawdowns, a fully indexed asset allocation strategy has merit. But there are few individuals (or institutions) with that degree of discipline and so adding some degree of active to the mix may be a pragmatic adjustment to an asset allocation strategy.

---

Learn To Use R For Portfolio Analysis
Quantitative Investment Portfolio Analytics In R:
An Introduction To R For Modeling Portfolio Risk and Return
By James Picerno

---