Most of the coverage of active and passive investing would have you believe that the world is firmly divided into two distinct and separate camps. But in reality, many investors like to have a combination of both. It's not an all-or-nothing proposition.
In fact, there's even a portfolio strategy, "core and explore" or "core and satellite," that incorporates elements of both styles.
"Philosophically, investors [who employ core and satellite] are saying, 'For the majority of my portfolio, I want to be well diversified and I want it to perform like the market, but I like the idea of taking some risk in an effort to outperform,'" said Michael Iachini, vice president and head of manager research at Charles Schwab Investment Advisory.
The traditional way to construct a core portfolio is with low-cost, widely diversified funds that represent large swaths of the market for the lion's share of a portfolio's assets. The idea is to access market exposure in the core portion, what's known as beta. Index mutual funds and exchange-traded funds are a low-cost way to access passive strategies, giving investors exposure to hundreds, if not thousands, of securities with one purchase.
"There are active funds out there trying to do the same thing but with some outperformance potential," said Iachini. "Of course, there's an added cost if you do that."
Investors who practice this approach say that 75 percent to 90 percent of the portfolio should be held in these types of investments.
With the explore portion, on the other hand, investor seek to gain an outperformance edge or they might want to express a conviction about the market, perhaps believing technology will continue its strong run or that international markets might edge out domestic ones given their slimmer valuations.
Actively managed funds are therefore used most often used for this portion of the portfolio. There's a widely held belief that managers can add value in smaller, less followed parts of the market. But that's not always the case. Because ETFs, and even some mutual funds, can invest in narrow slices of the market, it's possible to use passive funds for the satellite portion, too.
For example, an investor who wants to take a bet on emerging markets could use an ETF that tracks the MSCI Emerging Markets index. Someone who believes that biotech is poised to outperform could buy an ETF that follows the Nasdaq Biotechnology index.
"Investors buy around the markets as their views change," Iachini said.
Like anything in investing, there are lots of variations on how different investors employ the core and explore strategy.
Daniel Wallick, principal of Vanguard's Investment Strategy Group, dismisses the notion that the explore, or satellite, portion of the portfolio should be in active strategies.
"You can find good active management anywhere," he said. "But we've found that three needs to be present for active management to work: talent, low cost and patience."
When Wallick thinks about constructing a core and explore portfolio, he is just as likely to find worthwhile active managers in large-cap growth or technology as he is in small-cap value or emerging markets. "You can find talent in a lot of different places," he said.
Therefore, he starts with a market-cap weighted index as a building block for a portfolio. Then, he believes investors must hunt for the active managers they like. It's not so much filling a certain investment view or opinion, but finding a manager who can outperform. But he cautions that investors must have an expectation of outperformance, what's known in investment parlance as alpha. Otherwise, there's no point in taking on the additional risk — not to mention the added expense — of active management.
"Let's say you have a positive alpha expectation," Wallick said. "You have to balance that against the risk."
For Marina Gross, executive vice president of Natixis' portfolio research group, meanwhile, core and satellite should be constructed with mainly active funds. Instead of relying on market-following indexes for the core portion, she prefers actively managed offerings instead.
"A good active strategy requires a longer time horizon," she said. "You may not realize the full potential of the active strategy unless you let it play out longer term."
Gross prefers to use index funds for the satellite positions. "The satellite is meant to handle more tactical shifts because we're trying to adapt to changing market conditions."
With more trading in that part of the portfolio, Gross pointed out that the better tax efficiency of index funds can keep a portfolio's tax liability down. Even if investors trade frequently, they aren't as likely to get hit with a big tax bill as they would for actively managed offerings.
The core-and-explore strategy also has benefits for the investors who largely believe in indexing but still have an active management itch they want to scratch.
"Rationally they know that active management is going to drive up their investment costs, but they need that engagement," said Iachini at Charles Schwab Investment Advisory. "They're to stick with a more or less passive strategy if they still have the explore part of their portfolio."
Tim Clifford, certified financial advisor and managing partner with Core Wealth Consultants, sees this often with his younger clients. Many of them understand, intellectually, the rationale behind using low-cost, staid investments for their core. But they still want the thrill of outperformance if they can get it by choosing actively managed funds for a small portion.
"As they get older, three things happen," he said. "One, they lose interest. Two, they start realizing that they probably won't outperform. And three, they lose faith in their strategy."
— By Ilana Polyak, special to CNBC.com