By Xavier Brenner Investors and financial experts often get into heated debates over the pros and cons of passive and active investing. Yet what if there were a way to enjoy the best of both worlds? Actually, there is. It's called the core-satellite investing approach. The basic idea: combine the advantages of index funds—lower cost, broader diversification, tax efficiency and lower volatility—with the nimbleness of actively managed funds with the potential for outperformance.
Turkey and stuffing
It's the holiday season, so perhaps it's useful to imagine your portfolio as a big Thanksgiving spread. The main dish of your core portfolio might be passive index funds that are broadly representative of the financial markets. We're talking Turkey, stuffing and mashed potatoes here. This could include exchange-traded funds that track U.S. small and large caps equities as well as the fixed income market. Because indices change infrequently, transaction costs and capital gains tax are minimized. These core components will deliver stability since your portfolio will be fully diversified and mirror broad market trends. The portfolio's transaction costs and capital gains tax burden will also be minimized since indices don't reshuffle their lineup as often as actively managed mutual funds.
Then there are the satellite strategies that have the potential to deliver market-beating returns but require skilled active management. Think of these investments as those hard-to-make speciality dishes. Baked apple tartines with walnuts and Armagnac, anyone? Finding a hired hand to oversee your investments in such asset classes as international real estate investment trusts, commodities, high yield bonds and emerging markets may be an option. It's definitely prudent to consider using index funds in markets that are ultra-efficient and competitive like large-cap U.S. stocks. However, active managers, in some cases, may have a better shot of parlaying their expertise into superior returns in markets where there's less instantaneous information and more arbitrage opportunities. Active managers can move quickly to minimize potential losses when a particular company or sector suddenly hits the wall or falls out of favor with investors.