Active or Passive Funds?

Are actively managed or index stock funds best?

Yes.

I’m joking to make a point. By using both approaches strategically, you can get the best of both worlds.

Indexing is perfect for large-company stocks traded in highly efficient markets in the U.S., Europe and Japan. Actively managed funds are the way to go with small companies, emerging markets and REITS, where the manager can profit from inefficiencies.

I place about 60% of my clients’ equity portfolios in index funds and about 40% in actively managed funds. Whenever possible, I place active funds in tax-sheltered retirement accounts because they usually throw off higher taxable distributions than index funds.

Choosing fund type

First, decide which asset classes you want to invest in. Then, decide whether to use an active or passive approach. Choose only active funds that have both an excellent long-term record and reasonable fees.

I recommend investing in an S&P 500 index fund for your U.S. large-cap exposure. There’s no point in paying someone to actively manage U.S. large company stocks.

For U.S. small company stocks, I split the allocation evenly between index funds and actively managed funds.

Why use both strategies for the same asset class? The best active managers have provided similar returns as the index over the long term. Some years they do better, some years worse. To get as much diversification as possible, invest in both. By maintaining a 50% target for each, you can continually buy investments that have underperformed and sell investments that have outperformed.

Buying low and selling high is always a good idea.

International

I also recommend active funds for domestic and international REIT allocations and for natural resources stocks. For the latter, I like Vanguard Energy Fund Admiral Shares, which has a miniscule 0.28% expense ratio, lower than most index energy funds.

I use index funds for large-cap European and Japanese stocks. Japan’s sluggish economy makes investing in smaller Japanese companies unappealing. But big Japanese multinationals are truly global businesses that earn much of their revenue abroad.

For Pacific region emerging-market funds, I only use actively managed funds such as the T. Rowe Price New Asia Fund and the Matthews Pacific Tiger Fund. Emerging markets have less transparency and disclosure, and you need a skilled manager who watches each company in the fund like a hawk.

I also use actively managed funds for Latin America, including the T. Rowe Price Latin America Fund, which has outperformed the Lipper Latin America funds average over the last 10 years.

Rebalancing your portfolio

Investing the funds in your portfolio isn’t a one-time event. As some sectors do better or worse than others, the portfolio will get out of kilter. When that happens, rebalance to bring it back to the original allocations.

Periodic rebalancing both reduces risk and improves returns, many studies have shown.

With investors looking to set their strategy for 2013, now is a good time to make sure you’re using both active and passive funds to do the jobs they’re best suited for.

Paul Jacobs, CFP, is chief investment officer of Palisades Hudson Financial Group, based in its Atlanta office. Palisades Hudson is a fee-only financial planning firm and investment advisor with $1 billion under management. It is headquartered in Scarsdale, N.Y, and branch offices are in Atlanta, Ga., Portland, Ore., and Fort Lauderdale, Fla. He can be reached at paul@palisadeshudson.com.