In the debate over whether it’s best to invest actively or passively, it’s easy to lose track of the availability of a third option. Combining both investment approaches can be the better way to go.
Some investors prefer to invest exclusively in actively-managed mutual funds, while others are ardent supporters of index investing. But in the debate over which is the best way to invest, we don’t think there is an either/or answer. Rather, by combining both styles, you can build a more intelligent investment portfolio that provides more satisfactory results.
Here are three ways you can combine active and passive investing to achieve more satisfactory results:
■ Buy index funds or exchange-traded funds (ETFs) that track diversified, efficient markets. Buy actively-managed funds in narrower, less-efficient markets.
The Canadian stock market is heavily concentrated with financial stocks and resource stocks. This lack of diversification makes a Canadian index offering, such as iShares S&P/TSX 60 Index ETF (TSX—XIU), vulnerable to a setback in just one or two economic sectors.
To solve this problem, pair this ETF with at least one active Canadian equity fund in your portfolio that under-weights these sectors. An example from our Canadian Equity Funds Recommended list is CI Canadian Investment. It has 30 per cent of its assets invested in financial stocks, while iShares S&P/TSX 60 Index is 35-per-cent invested in the sector. And again, CI Canadian Investment has about 19 per cent of its assets in resource stocks, whereas the S&P/TSX 60 Index has about 31 per cent of weight in these stocks.
When you buy index offerings that track the broad US market, on the other hand, you can worry less about industry diversification. TD US Index Fund is diversified across 11 industry sectors and no single sector accounts for more than 25 per cent of its portfolio.
Less-efficient markets, meanwhile, are areas where skilled managers can often outperform their benchmarks. These markets are less actively traded and react to information more slowly. Small-cap indices are a good example of this type of market. And in Canada, small-cap indices are not only less efficient. They’re even more heavily concentrated in resource stocks than the larger-cap indices.
■ Use active and passive investing to reduce overall portfolio volatility. By pairing specific index funds or ETFs with similar managed funds that have lower historical volatility, you can reduce the overall volatility of your equity portfolio. For example, iShares S&P/TSX 60 Index ETF has a volatility rating of 7.5. It will pair well with Scotia Canadian Dividend, which has a lower volatility rating of 6.6.
■ Use active funds to beat the market. A big advantage of index mutual funds and ETFs, of course, is their low cost. Plus, they are more tax-efficient. But you can only expect to earn a return that roughly mirrors the performance of the fund’s benchmark index, minus fees, with these products.
If you want the opportunity to earn market-beating returns, however, then your only solution is active management. Problem is, though, many active managers don’t beat their benchmark indices. But there are managers out there who have done so, and may do so again.
One of our recommended Canadian equity funds, Mawer Canadian Equity, for example, has handily beaten its benchmark indices, the S&P/TSX Composite Total Return index, these past 10 years. Over this time, the fund’s annualized return is 9.2 per cent, which compares favorably with the Index’s return of 3.5 per cent. We think it’s still a good selection if you’re willing to accept the risk of underperforming to achieve long-term market-beating returns.
This is an edited version of an article that was originally published for subscribers in the February 2, 2018, issue of Money Reporter . You can profit from the award-winning advice subscribers receive regularly in Money Reporter. 
Money Reporter , MPL Communications Inc.
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