I enjoy endurance racing. There’s a lot of training leading up to the race, and over the years, I’ve had all kinds of training partners: fast, slow, energetic, less energetic, type A, type B, reliable, and unreliable.

A training partner who can “smooth the ride” is imperative. I need a partner who understands that my goal is to prepare (not over-prepare) for the race. Good partners push each other, but they also help each other recognize (and respect) their limits.

The power of an active/passive partnership

This same thought process can be applied to combining active and passive funds. Active funds offer the chance of outperformance—but also the chance of underperformance. Even if a portfolio is an outperformer over the long run, it will experience periods of underperformance. Those intermittent setbacks may tempt you to withdraw assets or abandon your long-term strategy.

In racing, the upside of excessive training is potentially being able to finish a few spots higher than normal. The downside is potentially injuring yourself and not being able to race.

As Figure 1 shows, the addition of a potentially more reliable partner (a broadly diversified, passively managed investment) can theoretically narrow the range of outcomes, helping you stick with a plan that offers the potential for outperformance while limiting the potential for significant underperformance.¹

Figure 1²

Active-only portfolio vs. active and passive portfolio

 

Note: This hypothetical example does not represent the return on any particular investment.

No matter how skillful an active manager, these setbacks—and the risks that come with them—are bound to materialize. For example, we ranked all active funds over a five-year period ended December 2011, and then we tracked the top performers (Top 20% of funds) over the next five-year period (ended 2016).

Figure 2a shows the results of this exercise. The majority of funds that were top performers over the first period didn’t outperform again. The funds that previously outperformed formed a distribution similar to the top chart in Figure 1.

In Figure 2b, we can see the impact of adding diversified passive index vehicles to portfolios consisting of prior top-performing active investments. First, as would be expected, the active/passive portfolio produced lower positive excess returns. Perhaps most important, though, the active/passive portfolio also reduced relative downside risk. The number of significant underperformers was reduced to 164, or 15% of the available funds (versus 397, or 36%, for the all-active portfolio shown in Figure 2a).

Figure 2a

Distribution of excess returns (above and below the benchmark) over five years ended 2016 for funds that ranked in the top quintile as of 2011

 

 

Figure 2b

Same distribution but adding 50% allocation to each fund’s style benchmark

Notes: The first figure includes all diversified U.S. equity funds that ranked in the top quintile for the five years ended 2011. The second figure includes the same funds but combines each fund with a passive index matching the fund’s investment style in a 50/50 ratio. To reflect implementation expenses, the index returns are reduced by 10 bps annually. Excess returns are measured relative to a fund’s stated benchmark. Data reflects excess returns over the period 2012–2016 for the 1,109 funds in the top quintile from 2007 through 2011. “Dead” funds refer to funds that were liquidated or merged between 2012 and 2016.

Sources: Vanguard calculations, based on data from Morningstar, Inc.

Active plus passive for the win

Using a diversified passive index investment can smooth the cyclicality of performance of an actively managed fund. This can reduce the impact of negative performance—and, consequently, the risk that you’ll be tempted to abandon your long-term plan.

We believe you’ll have the best chance for achieving success in active funds by seeking highly talented investment professionals, keeping low relative costs, and sticking to your long-term plan. So rather than active or passive, it’s better to think of active and passive. Like my best training partners, this combination can help nudge performance higher while limiting the risk of injury.

¹ Significant underperformance is -2% or more annually.

² Francis M. Kinniry Jr., CFA; Chris Tidmore, CFA, 2017. Enhanced practice management: Client risk and the case for active/passive combinations. Valley Forge, PA: The Vanguard Group.

Notes:

  • 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.
  • Past performance is no guarantee of future returns.
  • The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • Diversification does not ensure a profit or protect against a loss.