First, we look at the core portion of your portfolio. These assets will then be allocated to investments that are managed passively. For example, you could put half of the assets dedicated to stocks into an index fund that tracks the S&P 500.
For the actively managed portion, the goal is to select investments where a portfolio manager’s skill provides an opportunity to earn greater returns than those generated by the passive portion of your portfolio. In this example, you could put 10% of your portfolio into a high-yield bond fund and divide the remaining stock portion evenly between a biotechnology fund and a commodities fund.
Keep in mind: this portfolio is just an example. The core portion of the portfolio can be used to track any index — including those that intentionally reflect a style bias for value over growth, growth over value, government bonds over corporate bonds, domestic markets over foreign markets or whatever you prefer. Similarly, the sky’s the limit in the satellite portion.
The Essence of the Strategy
Regardless of the specific investments chosen to fulfill the asset allocation — cost, portfolio volatility and investment returns are the underlying considerations. A brief review of each area provides additional insight:
The core portion of the portfolio helps to minimize costs because passive investments are almost always less expensive than their active counterparts. Because passive investments track indices, the portfolio changes only when the index changes. And because indices change infrequently, transaction costs and capital gains tax are minimized. Active portfolio management, on the other hand, is based on trading. Each trade generates execution costs and potential tax liabilities in the form of capital gains.