3 Strategies for Building a Core Portfolio

As you build a long-term, core portfolio, there are often principles you may want to consider, like keeping costs down, ensuring tax-efficiency, and aligning your investments with your values.

Is that too much to ask? Not today, with innovation empowering individual investors to manage investments the way they want and need. But where do you begin? The answer is by thinking of the types of strategies to employ with your end goals in mind.

In this article, we'll look at three management strategies for building a core portfolio: passive investing, active investing, and direct indexing. We'll examine the pros and cons of each, and how using a blend of these strategies can help maximize their benefits while mitigating their drawbacks.

This strategy refers to funds that seek to replicate the performance of an underlying index, such as the S&P 500^®. Most index funds and exchange-traded funds (ETFs) fall under this category, which today accounts for more than half of all U.S. stock funds and nearly a third of all U.S. bond funds.

• Low cost: Ultralow fees associated with passive strategies explains a great deal of their popularity in recent years; the average index equity mutual fund had an average annual expense ratio of only 0.06 percent in 2020, and the average index equity ETF charged 0.18 percent. 

• Access: Thanks to rapid proliferation of index funds and ETFs in recent years, you can now gain exposure to many different segments, sectors, and geographies of the investing universe.  
• Transparency: It's easy to see what you own, since passive fund managers simply try to emulate an index and are therefore under no pressure to keep information on fund holdings private.  
• Tax efficiency: Because they typically don't trade that often, passively managed funds are less likely than active funds to generate capital-gains payouts.

• No potential for outperformance: Passive funds are graded on their ability to track their underlying index, so although generally they won't perform worse than the index they're tracking, they also won't perform better than it.

• Little flexibility: You're typically locked into a preset group of stocks or other securities, which only changes when the underlying index replaces an index member.

• Fear of missing out (FOMO): You might miss out on blockbuster gains of newer stocks that are still too small to be included in an index, whereas you might benefit from such gains by purchasing the stocks directly using active investing. 

Professional money managers run actively managed funds and seek to outperform their corresponding benchmarks, generate income, preserve capital, or achieve some other goal by deploying proprietary research for selecting specific investments. Their "active" nature typically comes from the more frequent trading that tends to occur within such funds.

• Potential for outperformance: Active managers can try to beat the market through correctly timed buy-and-sell decisions, and/or hedge against market declines.  
• Flexibility: Since they don't have to follow a specific index, active managers are more likely to have a solution that aligns with an investor's own market views/risk appetite.  
• Tax management: Active managers can opportunistically sell investments that are losing money to offset taxes owed on the winners.

• High cost: Active funds charge more since they require more management; the average annual expense ratio for an actively managed U.S. stock fund stood at 0.71 percent in 2020. 

• Potential for underperformance: The majority of actively managed funds fail to keep pace with the broader market, especially over longer time-periods, so manager selection is key to success in this approach.

• Lack of transparency: Active fund managers have to report their holdings on a quarterly basis only, which doesn't give investors a real-time look at what they own.

• Capital gains: Due to their relatively high turnover, active funds tend to have regular taxable events even when an investor isn't redeeming shares, and some of these gains can trigger capital gains taxes if capital losses aren't available for offsetting them. Also, these events are beyond the control of investors, so investors are often surprised by the impact of such holdings on their taxes.

Direct indexing allows investors to hold individual securities in an index as opposed to holding them through a mutual fund or ETF wrapper. This permits investors to take advantage of tax-loss harvesting, in which individual securities that have lost value can be sold to offset the capital-gains taxes from positions sold at a profit. Direct indexing also enables investors to tailor index holdings to their needs by allowing them to selectively exclude securities that don't align with their views or values. Because of these traits, direct indexing is seen as a hybrid approach that blends the best features of both passive and active strategies.

• Higher potential after-tax returns: Because direct indexing involves opportunistic tax-loss harvesting, investors have the potential to boost their after-tax returns, generating outperformance (i.e., "tax alpha") relative to the benchmark index and allowing the money that would have been used to pay capital gains taxes to stay invested. 

• Customization: Investors have the ability to tweak an index fund's holdings to suit their needs and values and address any overconcentration in outside stock positions.

• Transparency: Direct indexing offers the same level of real-time transparency as index funds and ETFs, and arguably even more 'control' over what they own than other alternatives.  
• Cost: Investors get some of the key benefits provided by actively managed funds, but at lower cost.  
• Charitable flexibility: With direct indexing, you can selectively donate individual stocks that have appreciated in value to avoid tax liability while helping others – something passive and active investing strategies can't offer because they can't unbundle groups of stocks.  
• Easy transitions: Because direct indexing strategies employ separately managed accounts, their holdings can be transitioned from one custodian to another without having to liquidate positions, which can generate an unwanted tax bill.

• Investment minimums: While technological advances have reduced the minimum amount of money required to invest in such funds, and therefore expanded availability, they are still high enough to potentially rule out some investors. 

• Stocks only: Direct indexing is currently not possible for many asset classes such as bonds or commodities, but technology and innovation may resolve these limitations in the future.  
• Cost: Since direct indexing requires a more active hand on the part of the manager, such funds are not as cheap as passively managed funds.

• Tracking error: The ability to customize holdings and engage in single-position tax-loss harvesting could cause returns to deviate from the benchmark index on a pre-tax basis.  
• FOMO: As with passive investing, you might miss out on blockbuster gains of newer stocks that are still too small to be included in an index, whereas you might benefit from such gains by purchasing the stocks directly using active investing. 

Deciding on which strategy to employ in your core portfolio ultimately depends on your unique situation. "Besides costs, you'll want to consider your goals, tax situation, risk capacity, risk tolerance, and personal values and perspectives. For many investors, a blend of both passive and active strategies tends to make the most sense," says Nitin Barve, CFA^®, Director of Portfolio Analysis and Advice Tools & Policy at the Schwab Center for Financial Research. For example, an investor might put the bulk of their portfolio in index funds and ETFs to keep their costs down, but turn to actively managed funds to help navigate the market's twists and turns at a tactical level to help protect against downside risks.

And now, thanks to the broader availability of direct indexing, investors have the option of both passive and active investing in one solution.