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 tend to have 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 mutual funds and exchange-traded funds (ETFs) fall into this category. 

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

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. 

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.