The financial media and industry commentators tend to polarise asset allocation as a debate between two sides: active and passive.

However, the reality is considerably more nuanced, and there is a clear process you can follow in selecting your approach without getting caught up in the rhetoric, according to a new research paper from Vanguard Australia.

"Discussions about active and index investing can draw some strong views from investors and their professional advisers, one way or the other," says Vanguard Australia's head of investment strategy, Aidan Geysen.

"We see active-passive not as a debate, but as an asset allocation decision, and this framework gives investors a clear process to help them determine the active and index allocations within their portfolio." 

Vanguard's "Making the implicit explicit: A framework for the active-passive decision" outlines a process to help navigate the broad range of variables that affect individual asset allocation decisions.

It sets out four key variables to consider:

1) Gross alpha expectation

With "alpha," a descriptor for above-benchmark investment returns, the above term refers to the expected outperformance you may expect from a given active strategy.

2) Cost of active management

This includes various fees and expenses associated with establishing and maintaining an actively managed fund, such as management expenses, transaction fees, initial expense ratios and other costs.

3) Active risk

The potential for underperformance by a given active strategy.

4) Risk tolerance

You should consider your tolerance for an active manager's potential underperformance; how much risk can your portfolio bear?

A key theme echoed throughout the report is that both active and passive investments have potential benefits within portfolios. Low-cost benchmark tracking and its result--a tighter range of relative returns--are significant advantages of passive investment vehicles, such as exchange-traded funds (ETFs).

Alternatively, active funds offer the potential for higher performance, in exchange for a wider range of uncertainty and typically higher costs.

The paper recognises that the process would be incomplete without a quantitative component, as the qualitative arguments are "arbitrarily based on implied assumptions".

In providing this quantitative framework, it introduces a three-tier process using active manager simulation, manager risk calculation, and a target active-passive allocator.

The active manager simulation models active manager performance over a 10-year period, for gross alpha expectations that are very low, low, neutral, high, and very high. For cost of the funds, and their active risk (tracking error), these are modelled for lower, moderate, and higher scenarios.

The second component of the model, manager risk calculation, compiles the distributions of each hypothetical 10,000-fund universe to calculate the range of performance uncertainty.

The third component uses active risk tolerance to assess the trade-offs between the active portfolio and the passive portfolio. As the paper explains, "this is completed for each of the 45 investor scenarios across three different active risk tolerance levels, for a total of 135 active-passive allocations".

This framework is applied to a case study, the results of which are outlined in a series of charts that can be viewed in the full report.

Ultimately, the research paper identifies three conclusions:

  • that indexing may be a valuable starting point for all investors,
  • it reiterates prior Vanguard research that shows active management's dependence on talent, cost, and patience,
  • investors considering both active and passive investments will benefit from explicitly identifying assumptions around the four key components of gross alpha, cost, manager risk, and risk tolerance.

In conclusion, it states: "Because this tailored approach is based on an investor's specific expectations, there will be no one-size-fits-all result."

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Glenn Freeman is a senior editor at Morningstar.

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