The debate between active and passive management may rage on for a long time. The reality, however, is that many investors own a little bit of both. Even passive investing's biggest fans still believe that active management has its place in the right circumstances.
But with so many actively managed funds and so many strategies, how do you choose the right one? And how do you know which strategy is worthwhile and which one won't add much to the portfolio?
When it comes to selecting an active strategy, the task is a bit more complicated, because it involves more than simply figuring out which corner of the market or style box to fill. You must also research a manager's investment style and track record, and then you must continually keep tabs on performance and any issues that arise. Not only is the style more active, but investors themselves must be active.
A handful of financial advisors offered ideas about how to evaluate actively managed funds and where they fit in a portfolio.
Start broad, then zero in
To find the right fund or strategy for a portfolio, advisors typically back into their investment selection. Dan Kern, chief investment officer at TFC Financial Management, for example, starts with asset allocation, which he believes is the most important investment decision. Asset allocation — your exact mix of investment categories such as stocks and bonds — is largely responsible for a portfolio's performance.
Only after you've settled on an asset allocation and know the type of investment style you are looking to fill can you home in on the right actively managed strategies. For example, if you conclude that you need some small cap growth exposure, then you can spend time evaluating just those types of funds instead of the entire universe.
Many investors make the mistake of being "collectors of funds," Kern said. They become enamored with several individual mutual or exchange-traded funds without considering how they all work together. They may not realize that those funds may have significant overlap and do little for actual portfolio diversification.
"I remember back in 2000 when I had clients tell me, 'I'm diversified; I have half a dozen funds,' but they were all tech funds or funds holdings big tech positions," Kern recalled. When the dot-com bubble burst, those portfolios took a big hit, because their holdings weren't balanced out by less volatile fare.
Find a worthy manager
Investing in active management means spending a lot of time on due diligence, said David Aaron, co-CEO and chief investment officer of EMM Wealth. Among the most important things he's looking for are managers who do what they say they will do.
"We try to understand if the manager is a closet indexer," he said. It's not worth paying more for active management, Aaron maintained, if a manager is simply replicating an index.
Others, like Kern, research managers to ensure they're experts in their strategies. For example, when small caps rallied at the end of 2016 after the election, Kern wanted to know which of the funds his clients own achieved the performance due to their own efforts rather than the general movement of the market.
'Core and explore'
Many advisors who use actively managed funds also use passive ones. They often combine them in a core and satellite strategy. The core of the portfolio consists of low-cost, broadly diversified index funds paired with actively managed funds that have the potential for outperformance.
"The part of the portfolio we call 'core' is doing what the market is doing, and we always have a position there," said Rod Holloway, a registered investment advisor and equity portfolio manager with Comprehensive Financial Consultants. "We wrap around that satellite positions of actively managed funds, and we're looking for active managers that have consistently outperformed."
The satellite portions of Holloway's portfolio are in areas of the market where he believes indexing is less reliable, such as emerging markets and microcaps.
"It's really difficult to get a lot of information on really small stocks, so we're looking for mutual funds where that's all they do and they have the expertise," he said.
Holloway tilts his satellite positions depending on market conditions and where he sees opportunities.
"If ever there was an environment that was conducive for active managers, this is it."
"But it's not market timing," he said. "The difference is that we're making small moves based on time horizon and objectives. We're never going all into cash or all into stocks."
And if he's wrong? "That's why the core component is always there, so if we're wrong, it's not a huge effect," he said.
For Ira Rapaport, a fee-only financial planner with New England Private Wealth Advisors, a core/satellite approach is even more important today because he believes the equity market is overvalued. By holding large stakes in the broad indexes, investors may be setting themselves up for declines if a downturn comes.
"If ever there was an environment that was conducive for active managers, this is it," he said.
For his satellite positions, Rapaport seeks out managers who can provide downside protection, perhaps by piling up cash positions or investing in defensive sectors.
— By Ilana Polyak, special to CNBC.com
Here are some investments that are fixed, keep up with inflation, don't have risk and are offered by insurance firms.
By understanding how one investment performs compared to another, you make better decisions about what's right for you.
Investors consume more info than can be processed so it's important to have a decision-making process for investments.
Congress' proposal to slash 401(k) contribution limit will affect the way American workers now save for retirement.
More From Active/Passive
Coverage of the World Economic Forum’s annual meeting in Davos, Switzerland.
Unlock the keys to building a successful long-term financial plan: manage your money, grow your money, and protect it.
Top health care investors, CEOs and technologists explore the innovations that will drive better outcomes, financially and clinically.
With Americans struggling to save for retirement, employers should consider upping their company match program.
In light of recent scandals, it's time for financial services firms to actively work to win or regain consumer trust.
A lack of fear leads to "irrational exuberance," when investors pay no attention to the fundamentals of investments.