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How to Use Active Funds in a Diversified Portfolio

Active management has been out of favor for a while–high fees, high tax burdens, and poor long-term performance. But with the slow rise of actively managed ETFs, which have lower costs and more tax efficiency than traditional active mutual funds, the gateway to active management has potentially been reopened. This is certainly a positive move, but cheaper more tax-efficient active funds don't answer the question of how should one use active exposures in a portfolio. We address this question in this post and propose several reasonable approaches one can take to incorporate active ETFs in to a diversified portfolio:

  1. Core-Satellite: The core of the portfolio is cheap index funds, the satellite funds are concentrated active ETFs.
  2. High-conviction: The core is active ETFs, combined with strategies and asset classes that tend to work well at different times.

Let's dig into each of the approaches in more detail.

Core-Satellite Approach:

The Core-Satellite approach is fairly simple — for the “core” of the portfolio (let's say 80%), invest in passive index funds. For the “satellite” of the portfolio (the other 20%), invest in highly active ETFs. Additional information can be found from the CFA institute and Vanguard.

Why would this be good for an advisor or a DIY investor?

One issue with going “all-in” on actively managed ETFs is that they tend to have a large deviations around an index (i.e., tracking error). For advisors who have to answer to short-horizon...