Active lessons to passive investing

As a general rule, the Hatfields aren't looking to the McCoys to learn any lessons about successful feuding.

But in mutual funds, there's little doubt that in the ever-raging debate between active and passive investors, the folks who believe in picking and choosing their issues can learn something from the people who build funds to emulate an index.

The basic debate boils down to management acumen.

Active investors believe a manager can add value — either by performing better on the upside or protecting them against declines. The indexer believes the best way to capture the profits of the market is to buy the market, rather than trying to beat it.

While the supporters of each strategy sometimes seem diametrically opposed, the truth is they can learn from each other, particularly at this time of year when many indexes are going through their annual or semiannual "reconstitution."

Russell Investment Group, of Tacoma, recently announced the preliminary annual changes being made on its broad-market Russell 3000.

In all, 277 new names will go onto the index, replacing companies that failed to keep up with the market's growth, were merged or taken private. Over the past 10 years, the average year has seen 405 names changed during the annual reconstitution.

When about 13 percent of the portfolio changes each year, one could question whether the passive indexing strategy actually takes an active bent.

It's not just Russell's benchmarks going through the process. Morningstar is in the process of its semiannual recalibration of the Morningstar U.S. Index.

Even new benchmarks like the Clear Spin-Off Index — a benchmark from Clear Indexes that looks at recently spun-off businesses — is going through its semiannual rejiggering.

The process is a form of active management, but done in an unemotional, detached sort of way.

If the people behind the indexes did not make changes, their benchmarks would quickly stray from their real purpose, replicating a specific segment of the market. To remain passively invested requires some level of active management.

For Russell, the repositioning is like regular maintenance, the next service checkup on the warranty plan. The indexes have rules, and the managers are just sticking to those guidelines.

Even an active investor should have their rules for running money. Most investment advisers, for example, suggest rebalancing either once a year, or whenever the portfolio is 5 to 10 percentage points off course.

But getting too tied up in seeking perfection — and reconfiguring a portfolio too frequently — creates its own set of problems.

Russell, Morningstar and the rest could change their benchmarks daily to stay perfectly on point, but the constant moves would defeat the purpose.

Chuck Jaffe is senior columnist at MarketWatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.