Can I invest 50% in index funds and 50% in active funds?

Last Updated on July 10, 2021 at 8:15 am

Let us discuss a question from a reader who prefers anonymity: “Is it ok to invest in 50% index funds (passive funds) and 50% active funds for the equity portfolio in my retirement portfolio?” The answer depends on what the motives behind such an allocation are. This discussion applies to any mix of active funds and passive funds.

If investors wish to have a “bit of this” and a “bit of that” approach “just in case”, then I am afraid it is just clutter. That is, they are on the fence wrt the active vs passive debate, unsure which will do better in future, so assume it is better to go halfsies! Adding more funds could make the entire equity portfolio track the “market” at a higher cost than a passive portfolio.

Passive investing needs conviction. Not the fanatic belief that their choice is the best but the confidence and the maturity that active fund performance will fluctuate; some will beat the market and some will not; that It can be pretty tiresome over the long run to keep chasing these winners and is far simpler to choose passive funds. After all, if an active fund produces inflation-beating returns, then so will a passive fund, so might as well save on the management fees.

Unless an investor has this conviction, this clarity, this maturity, they can never find happiness with passive investing, whether it is 100% of their portfolio or 10%. So if this 50:50 business is more due to a fear of missing out (on either option), it is likely to meet a sticky end.

Sure there is nothing terribly wrong with a 50:50 mix of active and passive funds in the same way as there is nothing wrong with holding 25 equity mutual funds in a portfolio. If this is you – “I am confused, I am not entirely sure which choice is better. so I want a mixture of the two”, then go ahead. Just do not assume or claim that this is better than 100% active or 100% passive – only time will decide that!

Amusingly after starting this article, I was shown an excerpt from a new mutual fund book (better left unnamed) which seems to be sponsored by AMCs. It recommends a small passive allocation (against best left unmentioned). Why? To benefit from this if that does not work and from that if this does not work.

What is amusing is, AMCs seems to want the best of both worlds: AUM from active and passive. They have recognised the increase in passive AUM in recent months and wish to fan the flame further. A business can afford to aimlessly clutter its portfolio with all sorts of NFOs, investors need to think twice.

Having interacted with investors for the last nine years, I can say with confidence and certainty that most investors neither have the ability and, more importantly, the courage to assess how well any mix of active + passive funds (including 0% of either) will do after they start investing.

Before we move ahead, let me reiterate: a mix (any mix) is ‘ok’ as long as you have the more important aspects of investing in place: the right inflation and portfolio return expectations, a reasonable asset allocation and de-risking strategy and most importantly a plan to keep investing more and more in the years to come. Sadly those who have a problem deciding which scattergun to buy often also have a problem in getting their “basics right”.

If your portfolio is small since you have just started investing, then it would better for you to choose passive funds and focus on more important aspects such as goal-based risk management and increasing your income and, therefore, investments in the future.

If you have been investing for a few years and wish to gradually increase allocation to passive funds without redeeming or switching from active funds, it is fine as long as passive funds become dominant in the next few years. You could then redeem from the active funds as and when you need to rebalance from equity to fixed income.

You could also gradually switch from active funds to passive (if you want to!) if your equity allocation is small (regardless of the number of years you have been investing) and if one or more funds are in “red” (loss). Then the switch will not cost you any tax.

The situation for older and heavier portfolios is a bit more tricky. Regular readers would be aware of the funds I hold, and they are all active. Suppose I stop further investments in them and invest all my future investments (meant for equity) into a passive fund and increase this investment at 10% a year; it would take more than 22 years for the index fund allocation to overtake my largest active fund. I have assumed the index fund grows at 10% CAGR and the active fund at 8% CAGR.

So adding an index fund to my portfolio would only clutter it up. I will have to make a huge switch to an index fund to be a meaningful passive investor. I see no point in paying tax to do that. I also see no point in fixing something that is not broken. The only consideration before me is the tax I would pay on switching more or less than the amount I would “lose” on fees in future? I do not know the answer to this. In any case, my frugal side will never permit me to pay taxes on something that seems unnecessary.

I am happy with my funds and believe that the power of inertia or doing nothing unless necessary is key to investing success. And IMO a change is neither meaningful nor necessary to my portfolio. Please do not misconstrue this as some attempt to get more returns. I have graduated from that stage, thankfully.

Fund management fees are certainly an important consideration but not the most important consideration. Investors should adopt a process-first, products-last approach. The process (clear goal target, variable asset allocation plan, review/rebalancing) has to be in place first, and this would naturally lead us to the right product categories. What we choose from these categories is largely a matter of personal choice. Just that we should not assume there is an ideal choice and our choice is the best. It usually never is, as it rarely gets validated.