If you plan to go passive, be prepared to make some active choices.
The fact is, financial advisors say, building a passive investment portfolio should involve more than simply plowing all your cash into one passively managed fund and calling it a day.
"Many consumers think that buying a [broad market] index fund is enough, but it's not that simple," said certified financial planner Chris Chen, a wealth strategist with Insight Financial Strategists.
Passive investing has been steadily gaining steam over time as investors pull their money from actively managed funds and instead pour it into lower-cost passively managed options, such as index funds and exchange-traded funds.
Each investment approach comes with pros and cons, and many financial advisors think employing a combination of both is the best strategy.
"We have found there aren't very good passive funds in certain categories, such as fixed income and alternative funds," said CFP Kevin Reardon, owner and president of Shakespeare Wealth Management. "The marketplace is changing rapidly, but for now, we still need active funds in some categories."
One benefit to using an active fund is that if it's managed well, it can outperform its benchmark. Passive funds, which generally track indexes, are married to the index's performance, for better or worse.
Nevertheless, there are some advisors who say they're able to build well-performing portfolios comprised solely of passive options for their clients.
From a broad perspective, a passive portfolio will likely consist of a mix of ETFs and/or index funds that provide exposure to both equities (stocks) and fixed income (bonds and/or cash). The exact percentage split will depend partly on when you need the money, which in industry lingo is called risk horizon.
If you're decades away from needing the money (read: retirement), your portfolio has time to recover from any scary shorter-term market swings. A long risk horizon means a larger portion of your portfolio can be more aggressively invested in stocks until you get closer to needing the money.
But sometimes that is derailed by low risk tolerance.
"We call it the stomach-acid test," said CFP Ashley Bleckner, a financial advisor with RS Crum. "It's about your comfort level with volatility and whether you'll be able to sleep at night if the market goes down 10 percent."
Advisors caution that if you react when market is zigzagging or wallowing in a stretch of bear territory, you risk selling at lows, eventually getting back into the market at higher prices and missing the gains while your cash was sidelined.
At any rate, once you determine how to divvy up your assets between those two main categories, your work isn't done.
On the equity side, Chen at Insight Financial Strategists said he broadly diversifies his clients' assets.
"You want your portfolio to be diversified across all asset classes so you can participate in the upward movement in any one of them," Chen said. "But if there's a downward movement in one of the asset classes, it will ideally be dampened by others [that don't go down]."
Chen divvies up the equity portion — in fairly equal chunks — among large-cap stocks, mid-cap stocks, small-cap stocks, real estate investment trusts, emerging markets, international stocks and commodities.
Chen and other advisors warn against trying to overweight an asset class that has been performing well.
"You'll be chasing returns," Chen said. "When you do that, you end up buying high and possibly selling low, which is the opposite of what you want to accomplish."
Once you've set the allocation of asset classes for the equity portion, the real fun starts. This is where you get to comb through roughly 1,300 index funds and 1,900 ETFs — whose ranks keep growing — to check out performance data, costs and asset information to cover all of your asset classes. (And just to keep things confusing for the rest of us, about 150 of those ETFs are actively managed.)
"We've seen passive outperformance ... over the last five years. But that doesn't necessarily mean it will happen again in the next five years."
Index funds, like their name suggests, track indexes. For instance, the Vanguard 500 Index Fund tracks the Standard & Poor's 500 index. But ETFs can do the same thing. The SPDR S&P 500, for instance, also tracks the S&P 500 index.
One difference is their liquidity. While less of an issue for retirement savers, it's worth noting that ETFs trade throughout the day like stocks. Shares in an index fund can be redeemed once a day.
ETFs tend to be the lower-cost option between the two. Data from research firm Morningstar show the average expense ratio across all ETFs is 0.56, compared with 0.83 for index funds. Both cost less than actively managed funds, whose expense ratio averages 1.2 percent.
"If you pay higher costs, it ends up costing you in returns in the long run," Chen said.
Also, make sure you get what you think you're buying. While a fund's name suggests what it's invested in, you can't know for sure unless you look under the hood. Luckily, ETF holdings are typically available on a daily basis.