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Considering active investing? 4 variables may help you decide

June 21, 2017

"What do we do now?"

Those are the words of Bill McKay in the classic movie The Candidate, which tells the story of McKay running for the U.S. Senate from California. The question comes up just after McKay learns he has been elected. He'd been so focused until then on his campaign that he now has no idea what to do next.

Many investors who are considering actively managed funds for their portfolios are faced with a similar question. They've identified low-cost, talented active managers who they think will outperform the market. But how much should they allocate to active strategies? In other words, what do they do now?

Until recently, answers to this question have been imprecise at best. But a new Vanguard research paper, Making the implicit explicit: A framework for the active-passive decision, aims to help the decision-making process by enabling investors to think more explicitly about their expectations and the risks they're willing to accept.

Uncertainty is part of the equation

Daniel WallickOften, the decision of how much in terms of active or passive investments to hold in a portfolio is a binary choice, said Daniel Wallick, a principal in Vanguard Investment Strategy Group and lead author of the new paper. Many investors, if they can access talented active managers at low cost, opt for an all-active allocation, he said.

But some uncertainty is inherent in any such decision. Let's say an investor has identified an active manager with a moderate net alpha expectation—that is, the anticipated level of outperformance minus costs. Despite the expectation of a positive return, the manager might still fail to outperform.

In that case, the modest size of the potential reward is probably not substantial enough for this investor to justify a 100% allocation to the active fund, Mr. Wallick said. The investor might be better off having some exposure to index funds to modify the risk.

Consider these key variables

The paper's framework can help determine whether you're a good candidate for entrusting assets to active management. More important, and as illustrated below, it can help establish active and passive allocation targets for a range of investors, based on four key variables:

  • Gross alpha expectation. Investors' anticipation of their ability to achieve successful outcomes through skill in selecting an active manager.
  • Cost of active investment. Low cost is the most effective quantitative factor an investor can use to improve the chance of success.
  • Active risk. The volatility of a fund relative to its target benchmark, and the uncertainty that an investor attaches to a particular manager.
  • Active risk tolerance. The degree to which an investor is willing to take on active risk in the pursuit of outperformance.

Are you a good candidate for active management?

Four variables—each shown on a sliding scale in the top figure—can help investors decide between active and passive allocations. For example, investors with high risk tolerances are likely to be more comfortable with actively managed investments. The bottom figure uses a simple question to walk through the same allocation decision.

Key decision factors

Step-by-step decision process

"Although some investors may view the active-passive decision as all-or-nothing, Vanguard believes it's more nuanced," Mr. Wallick said. "Indexing is a valuable starting point for all investors, and many may index their entire portfolio.

"But for those who expect to identify talented active managers, can access them at reasonable cost, and can tolerate active risk over time, an allocation to active management may be appropriate."

Note:

  • All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
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