Combining Active and Passive: Three Issues to Consider for Risk-Averse Investors

I was having a lively due diligence meeting with a retirement consultant the other day, discussing how our team manages Invesco Diversified Dividend Fund, and where we, as a conservative strategy, see opportunities and risks in the market today. Then came a moment of truth. The consultant sat back and said, “I really believe in what you all are doing, but many of my retirement plan committees just want passive index funds to bring down expenses.”

I understand that perspective. I’ve seen reports on how some active managers have struggled to beat their benchmark indexes. And I appreciate that expenses are a big concern, whether you’re a plan sponsor who’s choosing the constituents of a 401(k) plan, or whether you’re an individual investor trying to build a portfolio. But then I remembered something else the consultant mentioned to me earlier in the conversation: The retirement plan committees he works with were generally risk-averse and prefer to offer their participants more conservative strategies.

That’s when I knew that more context about active management was needed.

To me, the contradiction is stark between passive, market-cap-weighted funds on one hand and the desire for lower risk on the other. Why? Well, when you own a fund that tracks the S&P 500 Index, you not only earn market returns (minus expenses), you receive the full risk and volatility of the equity market as well. On the other hand, some active strategies seek to participate in the market’s upside while mitigating against the downside. When used correctly, I believe the addition of conservative, active funds can improve the experience of risk-averse investors who have devoted their portfolio to market-cap-weighted products.

In my opinion, there are three issues to consider:

  1. Risk diversification
  2. Active share
  3. Alpha consistency

Risk diversification

When building a diversified portfolio, it’s important to find strategies with different risk profiles, while considering your own long-term investment goals and appetite for risk. This is different than the traditional “style box” approach to diversification, which evaluates funds by the cap size (large, mid or small) and style (growth, core or value) of their stocks. Instead, risk diversification involves finding strategies that offer differing degrees of value at different points in the cycle, namely bull and bear markets.

Risk-averse investors, such as the retirement consultant I mentioned above, may want to consider conservative strategies that have a history of lower volatility to serve as an attractive complement to the full market-risk exposure of passive strategies. This type of “conservative/passive” framework creates a degree of market-cycle diversification, with the market-cap weighted funds providing inexpensive participation in bull markets and the conservative active fund providing the potential for downside mitigation in tough times.

Active share

When diversifying a passive portfolio with active funds, it’s important to consider the overlap between the active and passive strategies. In recent years, a popular method for evaluating this overlap has been active share. A fund has a higher active share when it:

  • Holds stocks that are not in the benchmark.
  • Leaves out stocks that are in the benchmark.
  • Holds the same companies as the benchmark, but in different weights.

There can be good reasons for a fund to have high active share (a differentiated, disciplined process) as well as not-so-good reasons (unexpected style drift). So it’s important for investors to evaluate active share numbers in the context of investment process, philosophy, manager experience and other qualitative measures.

Alpha consistency

There are plenty of reports that question the ability of active management to deliver alpha — or excess returns over the market. I disagree. I believe active managers can outperform over time, even after expenses (and a new Invesco study illustrates this1). I suggest evaluating a manager’s alpha over a full market cycle — which is a bull and bear market combined — as well as over long-term rolling periods such as five years to measure consistency.


The retirement plan sponsors I spoke about earlier were quite concerned with expenses, as they should be. But while expenses are always an important consideration, I believe the primary question should not be one of cost, but rather value. Diversifying a passive, market-cap-weighted index portfolio with an active, conservative manager offers the potential for delivering a lower risk profile, participating in market upside and managing expenses. You just have to make sure the funds are a good fit.

To read more about active share, and the results of a new Invesco study illustrating the outperformance of active management over market cycles, read Think Active Can’t Outperform? Think Again.

1 The study examined performance for approximately 3,000 equity mutual funds over the past 20 years. The study’s results accounted for fees. Mutual fund sales loads were not included in the calculations for the analysis.

Important information

The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the fund.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

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