Perhaps one of the most intensely debated topics in the investment management business is whether equity portfolios should be actively or passively managed. We all recognize the core argument of this debate, that is, does active management generate enough value to validate the cost of the higher fee structure. A related concern is whether a plan sponsor has assembled a mix of multiple managers that broadly diversify and manage to the same index resulting in a high-cost index fund. Valid arguments are plentiful on both sides of the active versus passive debate, but what I find interesting is that too often the approach is toward a mutually exclusive decision. In fact, investors would benefit from thinking about optimizing an overall equity portfolio using both passive and active strategies.

While it is true that active managers can have a difficult time outperforming a broad market index after fees, which typically range from 50 to 100 basis points, one should be cautious about adopting a 100% passively managed portfolio as the ideal solution. This is because, by the nature of capitalization-weighted indexes, choosing to be 100% passive is in effect an active and strategic bet on the largest capitalization stocks in indexes such as the Toronto Stock Exchange 300 and Standard & Poor's 500. This bet should not be a naive consequence of the portfolio management process, particularly in light of the fact that the risk in a cap-weighted index increases as the prices of the largest capitalization stocks rise.

Rebalancing in actively managed portfolios can mitigate this risk, however this is not an option for indexers. Tracking error, or differences in returns between actively managed portfolios and benchmark indexes, is influenced by the performance of large cap stocks. As many active managers tend to equal-weight stocks in their portfolios, it leads to these managers underperforming their benchmark when the largest-cap stocks in the index are outperforming. However, concentrating in large-cap stocks lessens diversification and falling large- cap prices leads to disappointing index results. Therefore, a combination of active and passive strategies can help maintain a broad capitalization exposure and avoid concentration in large caps.

CORE/SATELLITE APPROACH
What should one look for in active management when attempting to use both active and passive strategies? A core/satellite approach involves combining passively managed funds with focused actively managed mandates. The key is to not hold numerous diversified active portfolios when passive portfolios can provide diversification and cost effectiveness.

Since core exposure can be gained through index funds, this permits active mandate managers to focus on their best ideas, thus providing greater potential for generating alpha. Focused portfolios tend to have significant tracking error, in line with their target alpha. Realistically, if one is willing to pay 50 to 100 basis points in management fees, then large tracking error at times needs to be tolerated.

Concentration is a legitimate technique for generating superior returns in actively managed portfolios. This is not a contradiction to prudent portfolio management, rather it is taking the view that diversification concerns the equity fund as a whole and is not used to constrain single mandates. Clearly this approach raises the stakes in active manager selection.

The satellite component of the portfolio can be extended beyond long-only strategies. Long/short equity, hedged equity strategies, various arbitrage strategies and even distressed securities can play a vital role in diversifying the entire equity exposure.

In summary, active and passive portfolios can be combined to create well-diversified funds in a cost-effective way. The passive exposure provides inexpensive systematic exposure and helps maintain large-cap exposure. Active managers should be selected to provide stock or event-driven returns.