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 train (not overtrain) for the race. Good partners push each other, but they also help each other recognize their limits.
The same mindset 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 finishing a few spots higher than normal. The downside is potentially injuring yourself and not being able to race at all. Finding the right balance is the key. And the same holds true for investing.
The power of an active-passive partnership
As Figure 1 shows, the addition of a reliable investment 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 chances of significant underperformance.
Figure 1: A narrower range of outcomes
No matter how skillful an active manager, periods of underperformance—and the risks that come with them—are bound to materialize. For example, we ranked all active funds over a five-year period ending December 2011, and then we tracked the top performers over the next five-year period (ended 2016).
The blue bars in Figure 2 show how the top performers in the first period (2007–2011) performed in the second period (2012–2016). These previous top performers yielded a wide range of returns during the second period, similar to the pattern shown in the top of the chart in Figure 1.
The orange bars in Figure 2 show the impact of adding a diversified, passive index fund to a portfolio consisting of the formerly top-performing active investments. Adding this investment narrowed the range of potential outcomes, mitigating the risk of significant underperformance.*
Figure 2: Allocating 50% to a passive index fund narrows the distribution of excess returns for previously top-performing funds
Notes: The blue bars include all diversified U.S. equity funds that ranked in the top quintile for the five years ended 2011. The orange bars include the same funds but combine 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 basis points 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 are funds that no longer exist.
Sources: Vanguard and Morningstar, Inc.
Active plus passive for the win
Using a low-cost, diversified, passive index investment can smooth out the performance cycle 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. You can give yourself the best chance of active-investing success by choosing highly talented investment professionals, maintaining low relative costs, and sticking to your long-term plan.
Working with the right training partner in racing can nudge my performance higher and limit my risk of injury. Finding the right combination of active and passive investments in your portfolio may help you do the same.
Learn more about risk and the case for active/passive combinations in our recent research paper.
*Significant underperformance is –2% or more annually.
- All investing is subject to risk, including the possible loss of the money you invest.
- Diversification does not ensure a profit or protect against a loss.