It is one of the great debates in the investment industry: is the correct strategy passive or active investing?

Studies have shown that over long periods, passive index-based investing outperforms the vast majority of active managers. However, active managers point to their role in protecting a portfolio in down markets — which is to say that rather than matching the risk-adjusted return of some benchmark, they can deliver positive returns with less risk.

So, who is correct?

You could argue that both are correct or, at the same time, that both are wrong. In reality, the question of who is correct is probably the wrong question to ask.

A better question is: which approach is best suited to which type of investor? This is all about bringing together the concept of rebalancing a portfolio’s asset mix with the products that are used to build the portfolio.

Barclays Global Investors Canada Ltd.has done some interesting work in this area under the iShares brand. Rather than selecting one approach over the other, Barclays has built some presentations (you can view them at www.ishares.ca) that show an advisor how to blend active and passive strategies.

A cynic might say that this is a marketing plan that allows Barclays to get a percentage of every advi-sor’s book. But there’s nothing wrong with that if the arguments supporting the position make sense, which I believe they do in this case.

One of the presentations, entitled Achieving Balance: Blending index and active strategies, focuses on the ingredients of investment consulting, particularly as it relates to individual investing.

One slide that goes to the heart of the matter is entitled Ingredients of investment consulting. These ingredients include: science, defined as modern portfolio theory; art (portfolio implementation, strategic vs tactical); and managing client emotions (fear, greed and tax aversion).

Modern portfolio theory speaks to risk vs return at the portfolio level, which is to ask: over time, what blend of assets produces the best return for a given level of risk?

If I were to build a simple two asset portfolio made up of 50% bonds and 50% stocks, I may find that, historically, it has delivered say, 8% per annum, with a 3% standard deviation.

If I were to feed the same portfolio through a series of optimizer algorithms, I might end up with a portfolio that, in terms of risk vs return, resides in the northwest quadrant.

But therein lies the rub. All I have done is look in the rearview mirror. Is there really any model that supports a position that the same asset mix will produce the same return going forward? In fact, over short periods, such as one year or less, it is very unlikely that the future will look anything like the past.

Enter the second ingredient: art. If we are to optimize a portfolio based on what we saw in the rear-view mirror, then we should link the asset mix to the client’s personality. That is a passive portfolio-rebalancing approach known as “strategic asset allocation.”

In this sense, you are building a portfolio asset mix driven by the client’s objectives and risk profile. If your client has a balanced profile, the baseline starts from a 50/50 mix of bonds and equities. You could feed that asset mix through an optimizer in which the output has been restricted by the client’s profile. You might then end up with a portfolio that is somewhere between 40/60 to 60/40 bonds vs equities.

If we fed the same portfolio through an optimizer once a year, we would end up with a model that would be rebalanced back to the mandate at strategic intervals. Usually, the rebalancing occurs at the same time each year.

Here’s where the discussion of passive vs active gets blurred: certainly, rebalancing back to the client’s mandate is a passive strategy. But if, before doing that, we feed the portfolio through an optimizer each year, rebalancing looks more like a blend between passive (i.e., with the client mandate limiting the potential results) and active (fine-tuning through an optimizer).

Taking this concept to the next step, let’s consider the products used to make up the strategic asset mix. Are we holding index funds — say, iShares Canadian Broad Bond Index and, for simplicity, iShares S&P/TSX 60 Index? If so, then rebalancing back to mandate becomes a significant part of the process.

@page_break@But what if your client were holding, say, actively managed Canadian bond and Canadian equity funds? If the client is holding active funds, are we not, then, removing the role of rebalancing?

The only way to get a reasonable result running this portfolio through a limited optimizer would be to assume that both active managers were 100% invested in their core strategy. In other words, the bond manager is 100% invested in medium- to long-term bonds and the equities fund manager is 100% invested in equities.

Neither scenario is likely at a given point in time. What happens if the Canadian equities fund manager was holding 30% cash in the portfolio? Any attempt to optimize the asset mix on the assumption that the active manager was fully invested in equities would be skewed. Garbage in, garbage out.

Now, let’s move to the active side of the equation: “tactical” asset allocation. Instead of building an asset mix tied to the client’s investment profile, you are building it based on the outlook for global markets.

For example, if your econometric models suggest a high probability that interest rates will decline and the economy will slip into a recession, you might construct a portfolio that is 70%-80% bonds and 20%-30% equities.

But, as with strategic asset allocation, any rebalancing will depend on whether you are implementing your portfolio strategy using active managers or index funds. If you are implementing the strategy using the latter, rebalancing is fine. If it’s the former, re-balancing is rendered moot by our “garbage in, garbage out” mantra.

If you do rebalance, the optimizer provides a mix based on the data input, and in many cases, without any input about the client’s profile. That’s a dangerous game — and, for individual clients, would not likely sustain a reasonable suitability test. This takes us to the final ingredient: managing client emotions.

Barclays’ view is that the client’s tolerance for risk dictates what percent of the portfolio should be invested in active managers vs index products, arguing that lower risk tolerance dictates higher exposure to indexing.

This may be true, but only to a point. Certainly, it would apply to the bond component. But, for equities, you could argue that a lower risk tolerance dictates exposure to lower-risk value funds — those with managers who would be more apt to hold cash reserves during market peaks, presumably because value is harder to find at those times.

In the end, the great debate may be no debate at all. As we live in a world in which compliance checks require advisors to maintain reasonable suitability exposure, the client profile goes a long way toward determining any asset mix and, to a lesser extent, the choice of whether to use active managers vs passive indexed models in a portfolio. IE