The Myth of Core and Explore

Forbes recently had an article by Rick Ferri denouncing what is called "core and explore" -- using index funds as the core of your portfolio and adding actively managed funds in supposedly less-efficient asset classes like emerging markets and small-cap stocks. Since many investors seem to believe in this myth, I wanted to add my thoughts.

The origin of the core and explore approach is a study by the Schwab Center for Investment Research, "Core and Explore -- An Effective Strategy for Building your Portfolio." (I wrote about the problems with the study in my book What Wall Street Doesn't Want You to Know, published in 2000.)

Here are the three main conclusions of the original study:

• The core and explore approach reduced the risk of underperforming versus an all-explore approach.
• Core and explore provided more potential to beat the market versus an all-core approach.
• Emphasizing actively managed funds in the small-cap and international asset classes tended to increase a portfolio's potential to beat the market.

Adding Index Funds to an Active Portfolio
The first conclusion is adding core (index) funds to an all-explore (or actively managed) portfolio reduces the risk that an all-explore approach will underperform. That's obvious, since the core funds are the benchmark itself. Therefore, they can't underperform. If you don't want the risk of underperformance, why own any active managers? Strike one.

Adding Actively Managed Funds to an Indexed Portfolio
The second conclusion is that adding explore funds increases the chance of outperformance. If you own only core funds, you hold only funds that are their own benchmarks. Obviously, you can't get outperformance. Therefore, you obviously increase the chance of outperformance by adding explore funds. Of course, the more relevant conclusion is that you increase your chance of underperformance by a far greater amount! Strike two.

Outperforming in Inefficient Asset Classes
The third conclusion is that actively managed funds outperform in so-called "inefficient" asset classes. There are two problems with this. First, it's impossible for active managers to outperform in aggregate in any asset class because they must earn the same gross return as passive investors in that asset class. Since they have higher expenses, they must have lower net returns in aggregate. As William Sharpe noted in his paper The Arithmetic of Active Management, "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

The second problem is that the actual data shows that active managers don't outperform in any asset class. And perhaps their worst performance has been in emerging markets, because the costs of trading are so high. Strike three, you're out!

Active management is a loser's game in any asset class, simply because of costs. And while there will always be some active fund managers that beat the market, no one has yet found a way to identify the few winners ahead of time. That's why it's said that the road to investment hell is paved with past performance. The winning strategy is to use passively managed funds for your entire portfolio, not just the core.