Dear Dagen: What's the Right Mix of Index and Actively Managed Funds?

What do you think of the so-called "core and explore" approach to small- to mid-cap stocks and international asset classes, in which you put 30% to 40% in index funds and the balance in a managed fund?

-- Steve Raetzman

Steve,

I doubt the world needs another alliterative nickname or catch phrase. (I have had enough of the "Portly Pepperpot" references to Ms. Lewinsky.)

"Core and explore"* is another one of those jingly names, but it does actually refer to a popular strategy of mutual fund investing.

Simply, core and explore is the approach of combining index funds with actively managed funds. The goal is to minimize a portfolio's risk of trailing the market, while increasing its likelihood of beating it. I suppose that's really any investor's goal, isn't it?

By creating the "core" of a portfolio using index funds, an investor reaps the benefits of indexing, primarily comprehensive market representation and diversification at a low cost. Then specialized actively managed funds (the "explore" part of the equation) are added to the mix to deliver the possibility of beating the market.

As the thinking goes, actively managed funds will add the most value in the small-cap and international asset classes. Since these areas of the market are less efficient and under-researched when compared to large-cap U.S. stocks, living/breathing portfolio managers have a better chance of adding value and outperforming the appropriate benchmarks. The large-cap arena, on the other hand, is more efficient and scrutinized enough that most active managers have a difficult time beating the broader indices, primarily the S&P 500.

This approach certainly seems accurate when looking at mutual fund performance data from the past 10 years. At the end of April, only 56 out of 537 actively managed general equity funds outperformed the S&P 500 over 10 years, according to Lipper. But small-cap funds delivered an altogether different record. Covering the same 10-year period, 51 out of 72 actively managed small-cap funds outperformed the Russell 2000 index.

That's the theory. But it doesn't actually tell you exactly how to allocate your assets.

In a study unveiled in March, Charles Schwab (SCH) took this approach a step further by quantifying how much of each asset class should be given to index and actively managed funds, respectively.

Of course, you will first have to come up with an appropriate asset allocation for your overall portfolio. But the study, conducted by the Schwab Center for Investment Research, offers recommendations for the "core and explore" mixture within each asset class.

The screening process "looked for combinations of index and actively managed funds that had the highest probability of simultaneously outperforming the market by the largest amount, while underperforming the market by the smallest amount," according to the report.

The study suggested that if an investor wants exposure to large-cap U.S. stocks, then 80% of that asset class should be in index funds that track this broad portion of the market and only 20% should be in actively managed funds. For small-cap stocks, the study recommended that only 40% go into index funds and 60% into actively managed funds. For international exposure, the indexed portion is even smaller at 30%, while 70% should go into active management.

I spoke to three financial advisers who used both index and actively managed funds. All three agreed with the basic concept of mixing the two types of management, but they questioned Schwab's approach to putting specific allocation targets on each asset class. "There is no hard-and-fast notion," says Tim Schlindwein of Schlindwein Associates in Chicago. How much Schlindwein uses depends on the "outlook of the market and the needs of the client."

However, the Schwab study does stress that "these percentages are guidelines, not mandates." If you want to track the market even more closely, then increase your proportion of index funds. Certainly, some people may opt to put more of their money with active managers, while others may be comfortable to have their portfolios in nothing but index funds.

While on the subject of index funds, I had to call Vanguard to get the firm's insight.

I spoke to Jack Brod, a principal of asset management and trust services. Not surprisingly, Vanguard suggests using a "core index strategy" in which investors build a portfolio foundation in index funds, says Brod. You get market performance and diversification in a low-cost, more tax-efficient vehicle.

However, Vanguard also includes actively managed funds in its recommendations. In equities, the firm suggests having about half those assets in index funds and the other half in actively managed funds. Unlike Schwab, Vanguard doesn't recommend different levels of indexing based on different asset classes.

"We believe that indexing is just as powerful in all those asset classes," says Brod. The low cost is what makes indexing attractive across the board.

As with index funds, Vanguard's primary preoccupation when looking at actively managed funds is low cost. Also important is a fund's record of sticking to its stated objective

The approach to combining index and actively managed funds with one another may differ from adviser to adviser, firm to firm. But based on what the above professionals said, index funds are undoubtedly valuable in building the heart of a portfolio.

Unfortunately, not one word of this discussion involves how to pick the managers who would fill the active portion of a portfolio. The greatest difficulty is trying to figure out which active managers will outperform the market. I will defer to Brenda Buttner on that one.

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