Allocating between Active and Passive Management

Abstract

With the recent difficulty in beating the S&P 500 Index, the debate over active versus passive investing has risen to a new level of importance. We provide a framework for analyzing the trade-off the typical pension fund faces in deciding how much to index. Our analysis gets at the root of active performance—stock-picking skill. After analyzing the performance associated with various degrees of skill in various equity styles for the 1985–97 period, we found that a modest amount of stock-picking skill goes a long way and that the optimal amount of allocation to indexing declines as skill increases. For most risk categories, however, some allocation to indexing is appropriate.