Core Holdings: Passive, Active, or Direct Index?

When assembling a "core" investment portfolio—that is, the central chunk of investments that one keeps invested over the long term—many investors prefer to keep things simple by holding a collection of broad index-tracking funds. After all, these funds can offer low costs and a track record of steady performance. 

However, depending on the size of your portfolio, your goals, and your preferences, it can also make sense to complement a collection of passive index investments with some actively managed investments or direct-indexing strategies, with the goal of potentially filling out any gaps that could arise with a passive-only portfolio. 

Mixing strategies can make your core portfolio even more diverse, and potentially help you achieve other goals, whether you're looking for higher returns or looking for ways to manage risks. 

Here, we'll examine some of the pros and cons of each investing style to give you a sense of how they might be used together. 

Passive strategies seek to replicate the performance of an underlying index, such as the S&P 500^®, by holding similar securities in appropriate proportions. Most index funds and exchange-traded funds (ETFs) fall into this category. 

Pros:

• Low costs: The average index equity mutual fund had an average annual expense ratio of only 0.05 percent in 2022, while the average index equity ETF charged 0.16 percent, according to data compiled by the Investment Company Institute. 
• Access: Thanks to the rapid proliferation of index funds and ETFs in recent years, you can find funds offering exposure to many different asset classes, segments, sectors, and geographical targets.
• Transparency: Passive fund managers simply try to emulate the performance of an index and are therefore under no pressure to keep information on fund holdings private.
• Tax efficiency: Because they tend not to reconstitute their holdings that frequently, passively managed funds are less likely than active funds to generate capital-gains payouts.

Cons: 

• Outperformance unlikely: Passive funds promise to track the performance of a target index, not beat it. In general, these funds probably won't perform worse than the index they're tracking, but they're also unlikely to do better. 
• Little flexibility: You essentially get what's in the index, and that won't change unless the index does. This may prevent you from investing in securities that are currently not in the index or overweighting securities that you feel particularly optimistic about.  

Active funds are managed by professional money managers and can aim for a variety of different goals. These could include outperforming a benchmark, generating income, or preserving capital.  

Pros:

• Potential for outperformance: If the fund managers can make successful buy-and-sell decisions, and/or hedge against market declines, you stand to benefit.
• Flexibility: Since they don't have to mirror a specific index, active managers may offer proprietary strategies that align with an investor's own market views or risk appetite.
• Tax management: Active managers can seize opportunities to sell investments that are losing money to offset taxes owed on the winners.

Cons: 

• Higher costs: Active management costs money. As of 2022, the average annual expense ratio for an actively managed U.S. stock fund was 0.66 percent, according to the Investment Company Institute. 
• Potential for underperformance: Most actively managed funds fail to keep pace with the broader market, especially over longer time-periods. Choosing the right manager is key. 
• Lack of transparency: Active fund managers must report their holdings on a quarterly basis only, which doesn't give investors a real-time look at what they own. 
• Capital gains: Active strategies typically trade more frequently than passive strategies, which can lead to a lot of taxable events—even when an investor isn't redeeming shares. Some of these gains can trigger capital gains taxes if capital losses aren't available to offset them. The potential tax consequences could come as a surprise to investors used to managing their tax liability. 

With direct-indexing strategies, investors actually hold the individual securities in an index, rather than shares of a fund that holds them on their behalf. Direct ownership means index-like performance, on a pre-tax basis, but with opportunities for tax-loss harvesting and customization. In that sense, direct indexing is like a hybrid approach that blends features of both passive and active strategies. 

Pros:

• Higher potential after-tax returns: Seizing opportunities to harvest losses can boost after-tax returns relative to a traditional index fund. As a result, money that would have been used to pay capital gains taxes to stay invested. 
• Customization: You can also tweak your holdings to suit your needs. For example, you can exclude stocks that don't suit your values or might lead to overconcentration in certain areas (if you own lots of company stock, for example, and don't want to duplicate it with your index holdings).
• Transparency: Direct indexing offers the same level of real-time transparency as index funds and ETFs.
• Charitable opportunities: Direct ownership also creates opportunities to donate appreciated stocks. That's not possible with passive or active investing strategies.
• Easy transitions: Because direct indexing strategies are held in separately managed accounts, their holdings can be transitioned from one custodian to another without having to liquidate positions. Normally, such transfers can generate an unwanted tax bills. 

Cons:

• Investment minimums: It takes a decent amount of money to hold enough stocks to track a target index. 
• Stocks only: Direct indexing works only with stocks right now, so these strategies don't offer access to asset classes like bonds or commodities.
• Cost: Although direct-indexing strategies aim to track indexes, they require more oversight than a typical passive fund. That costs money. However, these strategies may still be cheaper to operate than fully actively managed funds.
• Tracking error: If you customize too much or harvest too many losses on a single stock, your portfolio might struggle to track your benchmark index.

Depending on your portfolio size, goals and needs, you could use any of these three strategies on their own as the core of your long-term investment portfolio. But they aren't mutually exclusive.

Allocating your core portfolio across these strategies could help you unlock some of the benefits of each, while managing their attendant downsides. For example, an investor might put the bulk of their core portfolio in index funds and ETFs to keep their costs down, while adding some actively managed funds for their potential to outperform. Similarly, they could use a direct-indexing strategy as their equity allocation—giving them index-tracking performance and potential opportunities to harvest losses for a tax break—and then passive and/or active strategies for their allocations to asset classes like fixed income or commodities. 

No two investors are alike, so these strategies can be mixed and matched accordingly. As usual, it's best to talk with a financial professional before deciding either way.