Best of both worlds: Core and explore investing

If you’re a longtime reader of MoneySense, you know the magazine has recommended Couch Potato investing for more than a decade. This simple strategy uses low-cost index funds designed to deliver the same returns as major stock and bond markets, with no attempt to outperform them. Yet you’ve no doubt noticed that many of the magazine’s covers also promise to help you pick winning stocks and top mutual funds that aim to beat the indexes. What gives? Isn’t that a contradiction?

Not really. While there’s a deep divide between investment extremists—ardent Couch Potatoes on one side and those who defend active management on the other—most people don’t see things in such black-and-white terms. There are shades of grey in between, and we don’t have to feel guilty about that. It’s entirely possible—and increasingly common—to combine both indexed and active strategies in a portfolio. In fact, while I’m a committed indexer myself, a small portion of my portfolio is actively managed. In what follows I’ll help you decide whether you should consider a so-called “core and explore” strategy, too.

The base case

Before we consider how you might combine indexing and active strategies, I must emphasize there is a mountain of theoretical and empirical support for the superiority of “passive” index investing. All the investment managers and private investors in the world are competing against each other. Together, they make up the market, and therefore passive and active investors collectively earn the market return before costs. But because active investors incur higher costs (due to management fees, transaction commissions, trading costs and taxes), as a group passive investors will always outperform their active counterparts. This holds true in both bull and bear markets. Hence, Couch Potato investing is incredibly appealing.

Note I said passive investors will always outperform as a group. This in no way precludes the possibility of outperformance by individual investors or fund managers. No one is denying that market-beating returns happen, and will continue to occur. The problem is they are extremely hard to identify in advance.

A long track record of good performance can be a predictor of future success, but the consensus of the many academic papers studying the matter is that the track record needs to be very long indeed. We don’t mean five or 10 years. The research suggests you need 20 years or more before you can draw meaningful conclusions. Managers who’ve enjoyed that kind of long-term success have little incentive to stick around another 20 years—because they’re filthy rich by then. So for all practical purposes, history is no guarantee of future outperformance. To quote Warren Buffett, “If past history is all there was to the game, the richest people would be librarians.”

So why do active investment strategies continue to be so popular? Mostly because it’s human nature to shoot for outsized returns. And while active investing may be something of a gamble, it’s not as reckless as playing the lottery with your life savings. If you’re prudent about active investing, the worst outcome is lagging the indexes by a few percentage points a year, which seems to be an acceptable trade-off to many investors.

A world to explore

“Core and explore” investing—or “core and satellite,” as it’s also called—isn’t new, but the basic idea has evolved over the years. Before index investing became as popular as it is today, core-and-explore portfolios were often 100% actively managed. You might have held 75% in a conservative fund of blue-chip stocks, for example, and 25% in aggressive, high-turnover, small-cap funds or emerging markets.

Today, however, the term generally refers to using a core of index funds for cheap access to the overall market (so-called “beta”), coupled with more expensive actively managed products and strategies designed to capture outperformance (“alpha”).

One method is to use a fully diversified Couch Potato strategy for the majority of your portfolio—think 70% to 90%. The explore portion would then be a go-anywhere, do-anything strategy with the simple goal of outperforming your starchy core. In fact, that’s sort of the point. Core and explore proponents usually seek out active strategies that are as different from the index as possible in order to avoid overlap with their inexpensive core holdings. That could mean hiring a specialized fund manager who deals in precious metals, or a hedge fund that focuses on mergers and acquisitions. Or you could pick your own stocks, if that floats your boat.

Another common strategy is using passive products actively: for example, you might use sector ETFs to move from defensive utilities to aggressive technology stocks when you think the timing is right. The sky’s the limit.

Another option is to index the most liquid asset classes and actively manage less efficient ones. So you might use index ETFs for your bonds and large-cap stocks, complemented with active strategies for small caps and emerging markets. Your assumption here is that skill matters more in less liquid asset classes, so it should be easier for active managers to beat their indexes. Emphasis on “assumption.”

Preet Banerjee is an independent personal finance commentator and a former adviser with a bank-owned brokerage. You can follow him on Twitter at @preetbanerjee